Costs (Edexcel A Level Economics A)

The Relationships Between Different Types of Costs

• Fixed costs are costs that do not change as the level of output changes

  • These have to be paid whether output is zero or 5000 

    • e.g. building rent, management salaries, insurance, bank loan repayments etc.

• Variable costs are costs that vary directly with output

  • These increase as output increases and vice versa

    • E.g. raw material costs, wages of workers directly involved in production

• Marginal cost is the cost of producing an additional unit of output

Cost calculations

Based on the above definitions, we can calculate several different types of costs

Cost Calculations Using the Above Formulas

Short-run Cost Curves

Concepts That Help to Provide Understanding of How the Cost Curves Are Derived

• In the short-run, the shapes of the cost curves (AC, AVC and MC) are determined by the law of diminishing marginal productivity
  

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 MP no longer increases

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

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

• With the hiring of the 7th worker, the MP turns negative which will decrease the total product

Connection between diminishing marginal returns and the cost curves

• As the marginal product increases, marginal costs decrease

  • There is an inverse relationship

    • Increasing returns = decreasing costs

    • Decreasing returns = increasing costs

Diagram analysis

• The distance between the AVC and AC = the 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 and 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

Short-run and Long-run Average Costs Curves

• Day to day operations of a firm occur in the short-run

• In the long-run, they are able to plan to increase the scale of production

  • E.g by increasing the size of the factory

  • Larger scale = more output and the firm moves onto a new SRAC curve in which the average unit costs are lower

• In the long-run, a growing firm is likely to keep repeating this process,

  • Each time a more efficient SRAC is generated

• The long-run average cost curve (LRAC) is the line of best fit between the lowest points of the short-run ATC curves