3.3.2 Costs

Edexcel A-Level Economics (9EC0) | Theme 3.3.2

Specification Coverage: Edexcel unit 3.3.2 - Costs. Students should be able to define and calculate the main cost measures, explain the shape of short-run and long-run cost curves, apply the law of diminishing returns, and analyse the relationships between MC, AVC, AC, SRAC, and LRAC.

Key Definitions

Fixed Costs (FC): Costs that do not vary with output, such as rent and salaries.

Variable Costs (VC): Costs that vary directly with output, such as raw materials and hourly wages.

Total Cost (TC): \( TC = TFC + TVC \)

Average Cost (AC): \( AC = TC / Q \)

Average Variable Cost (AVC): \( AVC = TVC / Q \)

Marginal Cost (MC): \( \Delta TC / \Delta Q \), which is the cost of producing one more unit.

Short-Run Cost Curves and Diminishing Returns

In the short run, at least one factor of production, such as capital, is fixed.

Adding more variable factors, such as labour, will initially increase productivity, but eventually diminishing marginal returns set in.

Short-run cost curves
Figure 1: Short-run cost curves showing the U-shaped nature of MC, AVC, and AC due to diminishing returns.

Why Are the Short-Run Curves U-Shaped?

  • Initially: Increasing returns and specialisation pull MC, AVC, and AC down.
  • Eventually: Diminishing returns cause MC to rise, which then pulls up AVC and AC.

The Relationship Between MC, AVC, and AC

When \( MC < AVC \), marginal cost pulls AVC down.

When \( MC > AVC \), marginal cost pulls AVC up.

This is why the MC curve cuts AVC at its minimum point. The same logic applies to the AC curve.

Long-Run Average Cost (LRAC)

In the long run, all factors are variable, so the firm can change its scale of production.

Long-run cost curves
Figure 2: Long-run average cost (LRAC) curve showing economies and diseconomies of scale.

Why Is LRAC U-Shaped?

  • Economies of scale: As output rises, LRAC falls.
  • Diseconomies of scale: Beyond a certain output, LRAC rises because of managerial inefficiencies and coordination problems.

The Relationship Between SRAC and LRAC

  • The LRAC is an envelope curve made up of all possible SRAC curves.
  • Each SRAC curve represents a firm with a particular fixed capital size.
  • The LRAC shows the lowest possible average cost for any given output when the firm can choose the most efficient scale.

Exam Preparation

  • Define and calculate the main cost measures, including TC, AC, AVC, and MC.
  • Draw the short-run cost curves and explain their U-shapes using the law of diminishing returns.
  • Explain why MC cuts AVC and AC at their minimum points.
  • Draw the LRAC curve and explain its shape using economies and diseconomies of scale.
  • Distinguish clearly between short-run diminishing returns and long-run economies or diseconomies of scale.