Economics » Cost and Industry Structure » The Structure of Costs in the Short Run

Key Concepts and Summary

Key Concepts and Summary

In a short-run perspective, a firm’s total costs can be divided into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.

Marginal cost is calculated by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.

Average total cost is calculated by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.

Average variable cost is calculated by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.

Glossary

average profit

profit divided by the quantity of output produced; profit margin

average total cost

total cost divided by the quantity of output

average variable cost

variable cost divided by the quantity of output

fixed cost

expenditure that must be made before production starts and that does not change regardless of the level of production

marginal cost

the additional cost of producing one more unit

total cost

the sum of fixed and variable costs of production

variable cost

cost of production that increases with the quantity produced

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