Short-Run Cost Theory
Different kinds of cost. Average costs and marginal costs.
Breakdown of Short-run Costs:
Fixed Costs: costs that do not change with output. They are the same no matter what you produced. An example of this is rent that you pay on a business property. If your rent is £1000 a month, no matter if you produce 1 unit or 1 million units your rental charge is still the same £1000.
Variable Costs: costs that do change with output. To put it simply, if you make more output, you pay more variable costs. An example of this is a hourly wage worker. If you want to produce more, you pay the worker for more hours worked.
Semi-fixed/Semi-variable Costs: this is a mix of the two. So your costs are fixed up until a certain point and anything after that point is variable. For example, electricity bills can be classified as semi-fixed. You have to pay them every month because without electricity your firm most likely could not run. However, let's say that you actually didn't consume any electricity. You would still be charged by the electricity company because there is a standing charge to pay which has to be paid regardless of what you produce.
Also, your firm probably needs a minimum amount of power to run that will be consistent each andevery month. These two elements are then fixed. The variable element comes in when your output increases and in turn the units of energy that you consume also increase.
Why do you need to know these different types of cost? Because:
Total Costs = Fixed Costs + Variable Costs
Average Cost = Average Fixed Costs + Average Variable Costs
Average Cost = Total Cost/Output
Average Cost Curve Diagram
Here are the different average cost curves you will need to know about. The most important is the ATC because this will be used in many diagrams. The lowest point of the curve is productive efficiency. This is where the firm maximises its output subject to minimising its average cost of production. The firm can produce more than this level, but its average cost will start to rise so this will be productively inefficient.
Marginal Cost: "the increase to your total cost when you produce one additional unit of output"
[Marginal cost is one of the concepts you have to get your head around in 2nd year Economics. In general, marginal cost or marginal product, marginal revenue (marginal anything) means how the total changes when there is one more unit. So marginal product is how much extra product is produced when there is one more factor of production employed. Marginal revenue is how much total revenue will rise/fall when one more unit of output is sold etc. Hopefully you see the pattern here.]
There is a link between ATC and MC as you can see on the diagram. MC always crosses through AC at the minimum point. When MC exceeds ATC, it means the cost of producing an extra unit of output is more than what the average cost per unit is currently. This means that the average cost will be pulled up more and more as you produce more units of output. This is why ATC rises after MC intersects it.
So, in summary you now know:
The difference between fixed and variable costs
Average costs and the three average cost curves
Marginal cost and the relationship between MC and AC
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