💰 Short-Run Cost Curves: Understanding Firm Behaviour 💰

Hey Economists! This chapter is absolutely critical for understanding how firms make decisions about how much to produce. When you know a firm's costs, you know its limitations, its potential profits, and its competitive edge. Think of costs as the backbone of supply! We are focusing specifically on the Short Run, where things are a little restrictive for the firm.

1. The Time Horizon: Short Run vs. Long Run

To understand short-run costs, we first need to define the time period we are looking at. Economists classify time into two periods based on a firm's ability to change its factors of production (FOPs).

What is the Short Run?
  • The Short Run is a period where at least one factor of production is Fixed (cannot be changed).
  • Typically, capital (like factory size, machinery, or building leases) is the fixed factor.
  • To increase output in the short run, a firm can only increase its Variable Factors (like labour or raw materials).
  • Analogy: A baker rents a tiny shop (fixed). If he wants to make more bread today, he can hire more staff and buy more flour (variable), but he cannot immediately build a bigger shop.
What is the Long Run?

The Long Run is a period where all factors of production are Variable. The firm can expand its factory, buy new machinery, or build a new office. (We save the long-run cost curves for a later topic!)

Quick Review: Fixed vs. Variable

Fixed Costs (FC): Costs that do not change with the level of output (e.g., rent, insurance, loan payments).

Variable Costs (VC): Costs that do change directly with the level of output (e.g., raw materials, hourly wages, electricity).

2. The Three Pillars of Cost: Total, Average, and Marginal

Firms need to measure their costs in three different ways to decide on their profit-maximising output. You must be able to calculate and interpret these three types of costs.

2.1. Total Costs (TC)

This is the simplest concept. It is the sum of all costs incurred by the firm.

\(TC = TFC + TVC\)

  • Total Fixed Cost (TFC): The total cost of fixed factors (e.g., $1000 rent). This line on a graph is horizontal.
  • Total Variable Cost (TVC): The total cost of variable factors (e.g., cost of flour increases as the baker makes more bread). This curve starts at the origin and rises.
  • Total Cost (TC): Starts at the level of TFC (because when output is zero, variable costs are zero, but fixed costs still exist) and runs parallel to the TVC curve.
2.2. Average Costs (AC)

Average costs tell the firm the cost of producing a single unit of output. This is vital because if the average cost is higher than the price they charge, the firm is losing money!

  • Average Fixed Cost (AFC): Fixed cost per unit of output.

    • \(AFC = \frac{TFC}{Q}\) (where Q is output)

    Memory Aid: AFC always falls as output increases because you are spreading the fixed cost over more units. This is known as the "Spreading the Overhead" effect.


  • Average Variable Cost (AVC): Variable cost per unit of output.

    • \(AVC = \frac{TVC}{Q}\)


  • Average Total Cost (ATC) (often just called AC): Total cost per unit of output.

    • \(ATC = \frac{TC}{Q}\) OR \(ATC = AFC + AVC\)

2.3. Marginal Cost (MC)

Marginal cost is arguably the most important cost concept for decision-making. It tells the firm the extra cost of producing just one more unit of output.

\(MC = \frac{\Delta TC}{\Delta Q}\) OR \(MC = \frac{\Delta TVC}{\Delta Q}\)

Note: Since TFC is constant, the change in Total Cost is equal to the change in Total Variable Cost. Marginal Cost ignores Fixed Costs.

Why is MC important? A rational firm will only produce an extra unit of output if the revenue earned from that unit (Marginal Revenue) is greater than the cost of producing it (Marginal Cost).

3. The Reason for the Shapes: Law of Diminishing Returns

Don't worry if this seems tricky at first—the reason all the short-run curves (except AFC) are U-shaped comes down to one fundamental principle:

What is the Law of Diminishing Returns?

The law of diminishing returns states that in the short run, if a firm increases a variable factor of production (like labour) while keeping at least one factor fixed (like capital), eventually the extra output generated by each additional unit of the variable factor will start to fall.

Think of it like this: You have a single check-out counter (fixed capital). When you hire the first cashier, productivity is high. When you hire the second and third, they help speed things up even more. But if you try to squeeze ten cashiers behind that one counter, they start bumping into each other, arguing over the cash register, and waiting for space. The 10th cashier adds very little, if any, extra output.

  • Initial Stage (Increasing Returns): Adding variable inputs boosts productivity, leading to falling Average and Marginal Costs.
  • Later Stage (Diminishing Returns): Overcrowding the fixed factor causes productivity to slow down and eventually fall, leading to rising Average and Marginal Costs.

This rise and fall in productivity is what creates the characteristic U-Shape of the short-run average and marginal cost curves.

4. Drawing and Interpreting Short-Run Cost Curves

You must be able to draw and interpret these curves. They are usually plotted with Cost (\($\)) on the Y-axis and Quantity (Q) on the X-axis.

The typical Short-Run Average Total Cost (SRATC or SAC) and Marginal Cost (SMC or MC) graph shows four crucial relationships:

  1. The AFC curve continuously slopes downwards (spreading the fixed cost).
  2. The AVC curve is U-shaped, initially falling due to efficiency gains, then rising due to diminishing returns.
  3. The ATC curve is also U-shaped. It is always above the AVC curve (because ATC = AVC + AFC). The gap between ATC and AVC shrinks as output rises (due to the falling AFC).
  4. The MC curve is U-shaped and falls faster than the AC curves, but then rises faster.

The Critical Relationship: MC and AC

The Marginal Cost curve always intersects both the Average Variable Cost (AVC) curve and the Average Total Cost (ATC) curve at their lowest points.

  • When MC is below AC: AC must be falling (the last unit was cheaper than the average, pulling the average down).
  • When MC is above AC: AC must be rising (the last unit was more expensive than the average, pulling the average up).
  • When MC = AC: AC is at its minimum point. This point of minimum ATC represents the productively efficient level of output in the short run.

Memory Aid: Think of your exam grades (AC) and your latest test score (MC). If your latest score (MC) is lower than your average (AC), your average drops. If your latest score (MC) is higher, your average increases.

5. Factors Affecting Short-Run Costs (Shifting the Curves)

The shape of the cost curves is determined by the fixed plant size and diminishing returns. However, the curves themselves can shift up or down due to changes in factor prices and productivity.

A. Changes in Factor Prices
  • Increase in Variable Factor Prices: If the cost of raw materials (a variable factor) increases, the TVC, AVC, and MC curves will shift upwards. TFC and AFC remain unchanged. Example: Global oil prices rise, making shipping costs more expensive for a manufacturer.
  • Increase in Fixed Factor Prices: If rent or insurance (a fixed factor) increases, the TFC, TC, AFC, and ATC curves will shift upwards. The TVC, AVC, and MC curves remain unchanged (because MC only measures the cost of the variable factor). Example: The annual property tax on the factory building increases.
B. Changes in Productivity

Productivity is key to cost reduction. If a factor becomes more productive, the cost per unit falls.

  • Increase in Labour Productivity: If workers (a variable factor) become more efficient (e.g., through training or new management techniques), the firm requires less labour time per unit of output. This leads to a decrease in TVC, AVC, and MC. The curves shift downwards.
  • Decrease in Factor Productivity: If machinery breaks down frequently, delaying production, costs per unit rise, and the curves shift upwards.
Key Takeaway for Short-Run Costs

Short-run costs are dominated by the trade-off between spreading fixed costs (making AC fall) and the consequences of the Law of Diminishing Returns (making MC and AC rise). The result is the characteristic U-shape. Changes in input prices or productivity cause the curves to shift.

Did you know? Many economists argue that in the real world, firms rarely experience the steep initial fall in costs predicted by the textbook U-shape. Instead, due to modern manufacturing flexibility, some firms see more of a ‘saucer’ shape or a very flat U-shape in their average costs over a large range of output!