Deal with Diagrams

Total Fixed and Variable Cost Curves

• This diagram shows the total fixed, total variable and total cost curves where there are constant returns to the variable factor.

• Fixed costs are fixed (!) and so the TFC curve will be constant at all levels of output. The TVC curve in this diagram increases at a constant rate showing constant returns to the variable factor. This will mean that the marginal cost is also constant. The TC curve is simply the fixed and variable costs added together and so runs parallel to the TVC curve, the gap between the two being the level of fixed costs.

Costs - Fixed Costs and Variable Costs

• This diagram shows the total fixed, total variable and total cost curves where there are increasing and then diminishing returns to the variable factor.

• The TVC curve in this diagram shows that there are initially increasing returns to the variable factor. This means that the TVC curve increases at a decreasing rate. Around the middle of the output range diminishing returns set in and the TVC curve continues to increase, but now at an increasing rate. The TC curve is simply the fixed and variable costs added together and so runs parallel to the TVC curve, the gap between the two being the level of fixed costs.

Costs

• These are the four principal cost curves that are usually drawn. They are the average total cost, the average fixed cost, the average variable cost and marginal cost curves.

• The average total cost curve is derived by adding together the average fixed and average variable cost curves. The average total cost curve, the average variable cost curve and the marginal cost curve are all u-shaped due to the presence of diminishing returns.

Average (Total) Cost

• Average cost is the cost per unit of output. The curve will tend to be u-shaped due to there initially being increasing returns and then subsequently diminishing returns.

• The average total cost curve is derived by adding together the average variable cost curve and the average fixed cost curve. The combination of these tends to mean that the average cost curve will be u-shaped. The main reason for this is the changing pattern of variable costs which are influenced by increasing and then diminishing returns.

Average Total Cost - Optimum Output

• The optimum level of output will be where the average cost curve is at a minimum. At this point the firm will have derived all the increasing returns they can, but diminishing returns have not yet set in. This point is the optimum level of productive efficiency.

Average Fixed Cost

• Average fixed cost is total fixed cost divided by output (the fixed cost per unit). The AFC curve slopes constantly downwards.

• The fixed costs stay constant whatever the level of output. This means that the fixed cost per unit will get smaller and smaller the higher the level of output. This is why the AFC curve slopes constantly downwards.

Average Variable Cost

• Average variable cost is the variable cost per unit of output. It is calculated by dividing the level of average variable cost by the level of output.

• In the short run a firm will find that some of their factors of production are fixed in quantity. This means that as they start to produce they will experience increasing returns to the variable factor, as the combination of factors becomes more efficient. This leads to the average variable cost falling. However, the firm will at some stage experience diminishing returns to the variable factor, and the average variable cost curve then starts to rise again. This is why the curve is usually drawn u-shaped.

Marginal Cost Curve

• The marginal cost is the increase in cost from producing one more unit. It tends to be drawn U-shaped.

• The marginal cost is calculated by taking the change in total cost. In the short run the marginal cost will eventually start to rise due to diminishing returns and that is why it is drawn u-shaped. Initially there may be increasing returns to the variable factor and marginal cost will fall, but eventually there will be diminishing returns and the marginal cost will start to rise.

Marginal Cost and Average Cost Curves

• The marginal cost and average cost curves are both normally drawn u-shaped due to increasing and then diminishing returns. Marginal cost will always intersect the average cost at the minimum point of the average cost curve.

• Both these curves are short run curves. The firm will be constrained in the short run by their fixed factors. As these cannot be changed, they can only alter their variable factors. As they do this, they will initially experience increasing returns and so MC and AC will both fall. However, eventually they will experience diminishing returns and MC and AC will start to rise again.

Marginal Cost, Average and Average Variable Cost

• The marginal cost, average and average variable cost curves are both normally drawn u-shaped due to increasing and then diminishing returns. Marginal cost will always intersect the average and average variable cost curves at their minimum points.

• All these curves are short run curves. The firm will be constrained in the short run by their fixed factors. As these cannot be changed, they can only alter their variable factors. As they do this, they will initially experience increasing returns and so MC, AC and AVC will both fall. However, eventually they will experience diminishing returns and MC, AC and AVC will start to rise again.

Long Run Average Cost Curve

• The long run average cost curve shows the least cost combination of producing each level of output.

• In this diagram the long run cost curve initially slopes downwards and this shows economies of scale. At Q1 cost per unit will be higher than at Q2 because the firm has not derived all the possible economies of scale. Beyond an output level of Q2 diseconomies of scale set in and cost per unit begins to rise.

Long Run Average Cost (Envelope) Curve

• The long run average cost curve is derived from a series of short run average cost curves and so is often described as the envelope curve.

• If a firm is producing in the most efficient way possible in the long run, but they then want to expand, they will have to expand along a short run average cost curve as they will be limited by their fixed factors. However, in the long run they can get more of the fixed factors and so will move back down to the long run average cost curve. This is why the LRAC is made up of a series of SRAC curves.

• Courtesy: http://www.bized.co.uk