Introductory Economics

Introduction

SHORT RUN COSTS: Short run costs are classified as fixed and variable costs.

Total Fixed Cost (TFC):
All costs associated with the fixed inputs. These costs do not vary with the level of production. They remain invariant in the short run, but in long run there are no fixed costs. These are also called overhead or sunk costs. Since total fixed cost remains constant irrespective of the level of output, the total fixed cost curve is parallel to the X-axis (Fig. 1).

• Incur even if the resource is not used.
• Does not change as the level of production changes (in the short run)
• Exist only in the short run.
• Not under the control of the manager in the short run.
• The only way to avoid fixed cost is to sell the item.

Examples: insurance, depreciation, mortgage, interest, etc.

Average Fixed Cost (AFC):
Cost per unit of output is called as average fixed cost. Since fixed cost is constant, as more output is produced, average fixed cost fall continuously, but at a decreasing rate. Therefore, AFC curve slopes downward throughout its length. Mathematically speaking, AFC curve becomes asymptotic to both the axes (Fig. 2).

Variable Cost (VC):
Variable costs (VC) are the costs that vary or change with the change in output. Variable costs are also known as operating costs, prime costs, on costs and direct costs. The variable costs vary directly with the level of output. Some of the characteristics of the variable costs are as under.

• Can be increased or decreased by the manager.
• VC = (the quantity of the input) ? (price of the inputs.)
• Increases as production increases.
• Total Variable cost (TVC) is the summation of the individual variable costs.
• Variable costs exist in the short-run as well as in long-run.
• In fact, all costs are considered to be variable in the long run.

Some examples of variable versus fixed costs:

• Fertilizer is a variable cost until it has been purchased and applied.
• Labour and cash rent contracts have to be considered fixed costs during the duration of the contract.
• Irrigation water is generally variable, but can have a fixed component.

Total Variable Cost (TVC): All costs associated with the variable inputs.

TVC = Px * X,

Where,

Px = cost of a variable input
X = variable input
The nature of the total variable cost is shown in Fig. 3.

• The total variable cost curve rises upward as the level of output increases. This shows that as the output is increased the total variable cost also increases. Total variable cost curve starts from the origin which implies that when the output is zero the total variable cost is also zero.

Average Variable Cost (AVC):

• Average variable cost is the cost per unit of output i.e. total cost divided by the number of units of output produced (Fig. 4). Thus average variable cost (AVC) is variable cost per unit of output.

The AVC curve is linked with the Average Production (AP) curve of the variable input.

• This shows that there is inverse relationship between AP and AVC. So as when AP is increasing AVC is decreasing, and when AP is decreasing, AVC is increasing. When AP is at maximum AVC is at its minimum (Fig. 5).

Total Cost (TC):

• As the name implies, the sum of total fixed cost (TFC) and total variable cost (TVC) is called the total cost (TC) as shown in Fig. 6.

TC = TFC + TVC
= K + Px * X

• In the short run TC will increase as only the TVC increases, since TFC is constant or fixed. TVC rises with the increase in output because the output can be increased only by the increase in the amount of variable input. So as output increases with the increase in the TVC, the TC must also rise, i.e. the TC is a function of output. Total cost curve is obtained by adding vertically TFC and TVC curves. Thus the vertical difference between TVC and TC curve is nothing but the TFC (Fig. 7).

Thus we summarize:

• TFC is constant and unaffected by output level.
• TVC is always increasing:
• First at a decreasing rate.
• Then at an increasing rate.
• TC is parallel to TVC:
• TC is higher than TVC by a distance equal to TFC.