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Microeconomics: Firms and cost in the short run

In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run. 
  • If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments.
Labor is often considered to be a part of the variable cost (VC). Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases).
  • Examples of variable costs include: utility bills, wages, raw materials
A firm's total cost (TC) is the sum of its variable and fixed costs.





As you can see, the fixed cost stays fixed no matter how much output is produced. Whereas the variable cost is represented by a monotonic increasing function. The total cost function is just the variable cost function where each point is raise by a vertical distance which is equal to that of the fixed cost.

 Marginal cost (MC): the change in total cost when one additional output is produced. It is the slope of total cost function. In other words the marginal cost is simply the derivative of the total cost with respect to output.

  • Since the function for fix cost is a constant, it does not influence the marginal cost function. However since VC and TC share the same slope, the marginal cost can also be found by taking the derivative of the variable cost function with respect to output (quantity).
  • A change in FC does not affect MC. However a change in VC results in a change in MC.
  • Usually an MC curve starts to decrease due to increasing marginal return, but will eventually increase due to diminishing marginal return.
Average fixed cost (AFC): the fixed cost of a firm divided by its total product (quantity). Initially a firms AFC is really high, but as production increases, the AFC gets closer and closer to zero.
Average variable cost (AVC): similar to the AFC, it is the average cost divided by the total product. A firm's AVC starts high, then it decreases and eventually it increases as the MC increases.
Average total cost(ATC): the total cost divided by the total product, which is also equal to the sum of the AFC and AVC. Initially, the  ATC decreases because of increasing returns as output increases, but eventually, as the MC experiences diminishing marginal returns, the ATC starts to increase.

  • As the total product increases, the AVC and ATC get closer (but will never touch). This is due to the fact that AFC becomes increasingly small as the firm increases production.

Graph:


 Try to use this graph to make sense of the new terms we have just learned. Also, notice that the MC intersects the AVC and ATC at their lowest points. Note that I used the FC,VC, and TC functions from the previous graph to obtain this result.

 Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 80-82.
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