Explaining the Shapes of the Cost Curves (AQA A Level Economics)

Diminishing Returns Shape the Short-run Cost Curves

• In the short-run, the shapes of the cost curves (AC, AVC & MC) are determined by the law of diminishing marginal returns. This fully explained on the page Diminishing Returns & Returns to Scale

Diagram: The law of Diminishing Marginal Returns

In the short run, marginal returns (MR) increase with the addition of three workers, after which diminishing returns occur with the addition of each individual worker

Diagram analysis

• A small food van selling burgers (product) at a music festival increases productivity up to the addition of a third worker

  • After that, workers get in each other's way and there is not enough grill space (capital) and the marginal return no longer increases

  • If more workers are hired, then the marginal return of each additional worker begins to fall

• Adding additional workers up to the 7th worker will keep increasing the total output

  • With the hiring of the 7th worker, the marginal return turns negative, which will decrease the total output

Using diminishing marginal returns to explain the short-run cost curves

• As the marginal returns increase, the marginal costs decrease

  • There is an inverse relationship

    • Increasing returns = decreasing costs

    • Decreasing returns = increasing costs

Diagram: Connecting the Shapes of the Short Run Cost Curves

The marginal cost curve is the supply curve of a firm. Marginal costs fall as long as there are increasing marginal returns

Diagram analysis

• The distance between the average variable cost (AVC) and the average cost (AC) = the average fixed cost (AFC)

  • AVC converges towards AC as the AFC continuously decreases with an increase in output

  • AVC decreases as additional workers are added and each worker produces additional product

• Marginal costs (MC) decrease initially as additional workers are added & the marginal product is increasing

• Diminishing returns begin when the MC starts to increase

• MC will cross the AVC and AC curves at their lowest point

  • As long as the cost of producing the next unit (MC) is lower than the average, it will pull down the average

  • When the cost of producing the next unit (MC) is higher than the average, it will pull up the average

The Impact of Costs & Productivity on Factor Inputs

• Factor prices (raw materials, wages, etc) and productivity shape a firm's costs of production and influence its choice of factor inputs

  • Factor inputs used in the production process can either be capital-intensive or labour-intensive

The influence of factor prices on costs

• Higher factor prices increase production costs, e.g. if wages rise due to labour market conditions or changes to the national minimum wage, a firm's labour costs will increase

• Lower factor prices reduce production costs e.g. if the cost of capital decreases, possibly due to interest rate reductions that make repayments more affordable, a firm's costs of production decrease

• Firms aim to minimise costs by selecting the optimal combination of inputs that maximises output

The influence of productivity on costs

• Productivity measures the efficiency with which inputs are utilised to produce output

• Higher productivity means more output can be produced with the same level of inputs

  • Improved productivity lowers a firm's production costs by reducing the number of inputs required to produce a given level of output

  • E.g. If technological advancements allow workers to produce more units per hour, the firm's labour costs per unit decrease

• Lower productivity increases costs because more inputs are needed to produce the same level of output

  • If workers become less efficient or if capital equipment becomes outdated, a firm's costs of production rise

The Influence of factor price and productivity on input

• Firms choose between capital and labour inputs based on factor prices and productivity levels

  • If capital (machinery) costs are low relative to labour costs and capital is highly productive, firms may opt to use more capital-intensive production methods

  • If labour costs are low and labour is highly productive, firms may prefer labor-intensive methods