The Market System – lecture 4
1. Costs in the short run
• Firm Decisions
➢ Quantity of output to supply → based on output price
➢ Technology choice → based on available technologies
➢ Quantity of inputs to demand → based on input prices (capital, land, labor)
• Short run characteristics:
➢ Some factors of production are fixed
➢ New firms cannot enter; existing firms cannot exit
• Cost concepts:
Total Cost (TC) Sum of fixed and variable costs → 𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
Fixed Cost (TFC) (=overhead costs) Costs that do not vary with output; expenses that remain
→ Not in long run constant
Variable Cost (TVC) Costs that change with output level
→ no variable costs in the very short run
Average Fixed Cost (AFC) 𝑇𝐹𝐶
Fixed cost per unit → 𝐴𝐹𝐶 =
𝑞
Average Variable Cost (AVC) 𝑇𝑉𝐶
Variable cost per unit of output(q) → 𝐴𝑉𝐶 =
𝑞
Marginal Cost (MC) ∆𝑇𝑉𝐶
Cost of producing one more unit → 𝑀𝐶 =
∆𝑞
→ reflect changes in variable costs
→ fixed costs makes no difference here
• Law of Diminishing Returns
➢ Adding more of a variable input to fixed inputs eventually leads to a decline in marginal product
→ Causes marginal cost to rise after a certain point
➢ In the short run, every firm faces:
Diminishing returns → rising marginal costs
Fixed factors → limited production capacity
• Short-Run Cost Relationships
➢ Total Variable Cost (TVC)
Always increases with output
∆𝑇𝑉𝐶
MC = slope of TVC → 𝑀𝐶 =
∆𝑞
➢ Marginal Cost (MC)
Initially may fall, but eventually increases due to diminishing returns
, • Relation between AVC and MC
➢ 𝑀𝐶 < 𝐴𝑉𝐶or 𝑀𝐶 < 𝐴𝑇𝐶 → AVC or ATC is declining
➢ 𝑀𝐶 > 𝐴𝑉𝐶or 𝑀𝐶 > 𝐴𝑇𝐶 → AVC or ATC is increasing
➢ 𝑀𝐶 = 𝐴𝑉𝐶or 𝑀𝐶 = 𝐴𝑇𝐶 → MC intersects AVC or ATC at
minimum point
• Relation between ATC and MC
➢ MC<ATC → ATC is declining
➢ MC>ATC → ATC is increasing
➢ MC=ATC → MC intersects ATC at its minimum point
• Cost formulas:
Total Cost (TC) TC = TFC + TVC
Average Total Cost (ATC) 𝑇𝐶
ATC =
𝑞
Average Fixed Cost (AFC) 𝑇𝐹𝐶
AFC =
𝑞
Average Variable Cost (AVC) 𝑇𝑉𝐶
AVC =
𝑞
• Cost Curve Shapes:
➢ TC Curve
Same shape as TVC curve
Always above TVC by the amount of TFC
➢ ATC Curve
ATC = AVC + AFC
As output increases:
▪ AFC declines
▪ AVC and ATC get closer, but never meet
1. Costs in the short run
• Firm Decisions
➢ Quantity of output to supply → based on output price
➢ Technology choice → based on available technologies
➢ Quantity of inputs to demand → based on input prices (capital, land, labor)
• Short run characteristics:
➢ Some factors of production are fixed
➢ New firms cannot enter; existing firms cannot exit
• Cost concepts:
Total Cost (TC) Sum of fixed and variable costs → 𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
Fixed Cost (TFC) (=overhead costs) Costs that do not vary with output; expenses that remain
→ Not in long run constant
Variable Cost (TVC) Costs that change with output level
→ no variable costs in the very short run
Average Fixed Cost (AFC) 𝑇𝐹𝐶
Fixed cost per unit → 𝐴𝐹𝐶 =
𝑞
Average Variable Cost (AVC) 𝑇𝑉𝐶
Variable cost per unit of output(q) → 𝐴𝑉𝐶 =
𝑞
Marginal Cost (MC) ∆𝑇𝑉𝐶
Cost of producing one more unit → 𝑀𝐶 =
∆𝑞
→ reflect changes in variable costs
→ fixed costs makes no difference here
• Law of Diminishing Returns
➢ Adding more of a variable input to fixed inputs eventually leads to a decline in marginal product
→ Causes marginal cost to rise after a certain point
➢ In the short run, every firm faces:
Diminishing returns → rising marginal costs
Fixed factors → limited production capacity
• Short-Run Cost Relationships
➢ Total Variable Cost (TVC)
Always increases with output
∆𝑇𝑉𝐶
MC = slope of TVC → 𝑀𝐶 =
∆𝑞
➢ Marginal Cost (MC)
Initially may fall, but eventually increases due to diminishing returns
, • Relation between AVC and MC
➢ 𝑀𝐶 < 𝐴𝑉𝐶or 𝑀𝐶 < 𝐴𝑇𝐶 → AVC or ATC is declining
➢ 𝑀𝐶 > 𝐴𝑉𝐶or 𝑀𝐶 > 𝐴𝑇𝐶 → AVC or ATC is increasing
➢ 𝑀𝐶 = 𝐴𝑉𝐶or 𝑀𝐶 = 𝐴𝑇𝐶 → MC intersects AVC or ATC at
minimum point
• Relation between ATC and MC
➢ MC<ATC → ATC is declining
➢ MC>ATC → ATC is increasing
➢ MC=ATC → MC intersects ATC at its minimum point
• Cost formulas:
Total Cost (TC) TC = TFC + TVC
Average Total Cost (ATC) 𝑇𝐶
ATC =
𝑞
Average Fixed Cost (AFC) 𝑇𝐹𝐶
AFC =
𝑞
Average Variable Cost (AVC) 𝑇𝑉𝐶
AVC =
𝑞
• Cost Curve Shapes:
➢ TC Curve
Same shape as TVC curve
Always above TVC by the amount of TFC
➢ ATC Curve
ATC = AVC + AFC
As output increases:
▪ AFC declines
▪ AVC and ATC get closer, but never meet
