ARELLANO UNIVERSITY

Microeconomics
Chap. 4. Short Run Costs and
Output Decisions

Professor: Dr. Ronaldo A. Poblete, CFMP

 Costs in the Short Run
Short run is that period during which two
conditions hold: (1) existing firms face limits
imposed by some fixed factor of production, and (2)
new firms cannot enter and existing firms cannot
exit an industry.
These costs must be paid even if the firm
stops producing—that is, even if output is zero.
These costs are called fixed costs, and firms can
do nothing in the short run to avoid them or to
change them. In the long run, a firm has no fixed
costs because it can expand, contract, or exit the
industry.
 Costs in the Short Run
Firms also have certain costs in the short run
that depend on the level of output they have
chosen. These kinds of costs are called variable
costs. Total fixed costs and total variable costs
together make up total costs:
TC = TFC + TVC
where TC denotes total costs, TFC denotes
total fixed costs, and TVC denotes total variable
costs. We will return to this equation after
discussing fixed costs and variable costs in detail.
 Fixed Costs
Total Fixed Cost (TFC) Total fixed cost
is sometimes called overhead. There may
also be insurance premiums, taxes, and city
fees to pay, as well as contract obligations to
workers.
Fixed costs represent a larger portion of
total costs for some firms than for others.
Electric companies, for instance, maintain
generating plants, thousands of miles of
distribution wires, poles, transformers, and so
 Fixed Costs
Total fixed costs (TFC) or overhead are
those costs that do not change with output
even if output is zero. Column 2 of Table 8.1
presents data on the fixed costs of a hypothetical
firm. Fixed costs are $1,000 at all levels of output
(q). Figure 8.2(a) shows total fixed costs as a
function of output. Because TFC does not
change with output, the graph is simply a straight
horizontal line at $1,000. The important thing to
remember here is that firms have no control over
fixed costs in the short run.
Total Fixed Costs
 Average Fixed Costs
It is total fixed cost (TFC) divided by the number of
units of output (q):
TFC
AFC = --------------
Q
For example, if the firm in Figure 8.2 produced 3
units of output, average fixed costs would be $333 ($1,000
3). If the same firm produced 5 units of output, average
fixed cost would be $200 ($1,000 / 5).
Average fixed cost falls as output rises because the
same total is being spread over, or divided by, a larger
number of units (see column 3 of Table 8.1). This
phenomenon is sometimes called spreading overhead.
Average Fixed Costs
 Variable Costs
Total Variable Cost (TVC) Total variable cost (TVC)is
the sum of those costs that vary with the level of output in
the short run. To produce more output, a firm uses more
inputs. The cost of additional output depends directly on
what additional inputs are required and how much they
cost.
The total variable cost curve is a graph that shows
the relationship between total variable cost and the level of
a firm’s output (q).At any given level of output, total variable
cost depends on (1) the techniques of production that are
available and (2) the prices of the inputs required by each
technology. To examine this relationship in more detail, let
us look at some hypothetical production figures.
Variable Costs
Variable Costs
 Marginal Cost
The most important of all cost concepts is that
of marginal cost (MC), the increase in total cost that
results from the production of 1 more unit of output.
Let us say, for example, that a firm is producing 1,000
units of output per period and decides to raise its rate
of output to 1,001. Producing the extra unit raises
costs, and the increase—that is, the cost of producing
the 1,001st unit—is the marginal cost. Focusing on
the “margin” is one way of looking at variable costs:
marginal costs reflect changes in variable costs
because they vary when output changes. Fixed costs
do not change when output changes.
Marginal Costs
 The Shape of the Marginal
Cost Curve in the Short Run
The assumption of a fixed factor of
production in the short run means that a firm is
stuck at its current scale of operation (in our
example, the size of the plant). As a firm tries to
increase its output, it will eventually find itself
trapped by that scale. Thus, our definition of the
short run also implies that marginal cost
eventually rises with output. The firm can hire
more labor and use more materials— that is, it
can add variable inputs—but diminishing returns
eventually set in.
In the short run, every firm is constrained by some fixed input that (1)
leads to diminishing returns to variable inputs and (2) limits its capacity
to produce. As a firm approaches that capacity, it becomes increasingly
costly to produce successively higher levels of output. Marginal costs
ultimately increase with output in the short run.
 Graphing Total Variable
Costs and Marginal Costs
Figure 8.5 shows the total variable cost curve
and the marginal cost curve of a typical firm.
Notice first that the shape of the marginal cost
curve is consistent with short-run diminishing
returns. At first, MC declines, but eventually the
fixed factor of production begins to constrain the
firm and marginal cost rises. Up to 100 units of
output, producing each successive unit of output
costs slightly less than producing the one before.
Beyond 100 units, however, the cost of each
successive unit is greater than the one before.
 Graphing Total Variable
Costs and Marginal Costs
 Average Variable Cost (AVC)
Average variable cost (AVC)is total variable cost
divided by the number of units of output (q):
TVC
AVC = ---------
Q
In Table 8.4, we calculate AVC in column 4 by
dividing the numbers in column 2 (TVC) by the numbers
in column 1 (q). For example, if the total variable cost of
producing 5 units of output is $42,then the average
variable cost is $42 / 5, or $8.40. Marginal cost is the
cost of 1 additional unit. Average variable cost is the total
variable cost divided by the total number of units
produced.
Average Variable Cost (AVC)
 Graphing Average Variable
Costs and Marginal Costs
The relationship between average variable cost and
marginal cost can be illustrated graphically. When marginal cost is
below average variable cost, average variable cost declines
toward it. When marginal cost is above average variable cost,
average variable cost increases toward it.
Figure 8.6 duplicates the bottom graph for a typical firm in
Figure 8.5 but adds average variable cost. As the graph shows,
average variable cost follows marginal cost but lags behind. As we
move from left to right, we are looking at higher and higher levels
of output per period. As we increase production, marginal cost—
which at low levels of production is above $3.50 per unit— falls as
coordination and cooperation begin to play a role. At 100 units of
output, marginal cost has fallen to $2.50.Notice that average
variable cost falls as well, but not as rapidly as marginal cost.
Graphing Average Variable
Costs and Marginal Costs
 Total Costs

We are now ready to complete the cost

picture by adding total fixed costs to total
variable costs. Recall that
TC = TFC + TVC
Total cost is graphed in Figure 8.7,where
the same vertical distance (equal to TFC,
which is constant) is simply added to TVC at
every level of output. In Table 8.4, column 6
adds the total fixed cost of $1,000 to total
variable cost to arrive at total cost.
 Average Total Cost (ATC)
Average total cost (ATC)is total cost divided
by the number of units of output (q):
TC
ATC =--------
Q
Column 8 in Table 8.4 shows the result of
dividing the costs in column 6 by the quantities in
column 1. For example, at 5 units of output, total
cost is $1,042; average total cost is $1,042 / 5, or
$208.40.The average total cost of producing 500
units of output is only $18—that is,$9,000 / 500.
 Average Total Cost (ATC)
Another, more revealing, way of deriving average total cost
is to add average fixed cost and average variable cost together:
ATC = AFC + AVC
For example, column 8 in Table 8.4 is the sum of column 4
(AVC) and column 7 (AFC).
 The Relationship Between Average
Total Cost and Marginal Cost

The relationship between average total cost

and marginal cost is exactly the same as the
relationship between average variable cost and
marginal cost. The average total cost curve follows
the marginal cost curve but lags behind because it is
an average over all units of output. The average
total cost curve lags behind the marginal cost curve
even more than the average variable cost curve
does because the cost of each added unit of
production is now averaged not only with the
variable cost of all previous units produced but also
 The Relationship Between Average
Total Cost and Marginal Cost

Fixed costs equal $1,000 and are incurred

even when the output level is zero. Thus, the first
unit of output in the example in Table 8.4 costs
$10 in variable cost to produce. The second unit
costs only $8 in variable cost to produce. The
total cost of 2 units is $1,018; average total cost
of the two is ($1,010 + $8)/2, or $509. The
marginal cost of the third unit is only $6. The total
cost of 3 units is thus $1,024, or $1,018 + $6,
and the average total cost of 3 units is ($1,010 +
$8 + $6)/3,or $341.
As you saw with the test scores example, marginal cost is what drives changes in
average total cost. If marginal cost is below average total cost, average total cost
will decline toward marginal cost. If marginal cost is above average total cost,
average total cost will increase. As a result, marginal cost intersects average total
cost at ATC’s minimum point for the same reason that it intersects the average
variable cost curve at its minimum point.