3.3.2 - Costs

Time Periods and Cost Building Blocks

The first distinction is between the short run and the long run. In the short run, at least one factor of production is fixed. A firm can usually vary labour, raw materials, or hours worked quite quickly, but it cannot instantly change the size of its factory, install a new production line, or move site. In the long run, all factors are variable, so the firm can change its whole scale of operation.

Fixed costs include items such as rent, insurance, business rates, and lease payments on machinery. Variable costs change with output, so ingredients, packaging, hourly wages, and some energy use are usually variable. A Greggs branch, for example, still pays rent on a quiet day, but flour, paper bags, and some staffing costs rise when more pastries are sold.

Total cost is the sum of fixed cost and variable cost. That is why economists separate them: in the short run, firms usually change output by changing variable inputs, while fixed costs still have to be paid even if output is low.

Measuring Costs

To compare different output levels, firms need more than total cost. They also need cost per unit and the cost of the next unit.

Average cost tells us the cost per unit. It can be split into average fixed cost and average variable cost. Because total cost is made up of fixed and variable cost, average total cost must also equal average fixed cost plus average variable cost.

Marginal cost is the extra cost of the next unit, not the cost of all units together. Because fixed costs do not change as output changes, marginal cost can be found from the change in total cost or from the change in total variable cost alone.

One pattern follows immediately. Average fixed cost must fall as output rises, because the same fixed amount is being spread over more units. It gets smaller and smaller as output increases, even though the rate of fall slows. This is why firms often get a strong fall in unit costs when they move away from very low output.

Why Short-Run Costs Change Shape

Short-run cost curves are shaped by what happens to productivity when a firm keeps adding variable inputs to a fixed factor.

At first, adding extra labour can make production more efficient. Workers can specialise, machines are used more fully, and output rises quickly. But once the fixed factor becomes crowded, each extra worker adds less extra output than the previous one. If the kitchen, shop floor, or production line is already busy, more workers begin to share the same fixed space and equipment.

That is why marginal cost is usually U-shaped in the short run. It may fall at first when productivity is improving, but once diminishing marginal productivity sets in, each extra unit of output requires more extra input, so the cost of the next unit rises. Average variable cost follows the same basic logic, because variable cost per unit falls at first and then rises. Average total cost is also usually U-shaped, but it lies above average variable cost because it also includes fixed cost.

This also explains two common exam relationships. First, the gap between average total cost and average variable cost is average fixed cost, so that gap gets smaller as output rises. Second, marginal cost cuts both average variable cost and average total cost at their minimum points. If the next unit costs less than the current average, it pulls the average down. If it costs more than the current average, it pushes the average up.

In practice, this is easy to see in a busy Greggs shop. Extra staff during the morning rush may initially raise output quickly because ovens and counters are being used more intensively. But once oven space and counter space are fully stretched, extra workers start getting in each other's way, so the cost of producing more items rises.