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Wize University Microeconomics Textbook > Production and Costs

Fixed Costs and Variable Costs

Average Product and Marginal ProductPrevious Section
Long Run CostsNext Section
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Fixed Costs and Variable Costs

  • Fixed costs are costs that do not change with the level of output and they only occur in the short run. Example: Factory rent and cost of machines


  • Variable costs are costs that do vary with the level of output. They can occur in the short run and long run. Example: Wages paid to workers and cost of raw materials



  • Marginal cost is the additional cost of producing one more unit.

Total Cost(TC)= Total Fixed Cost (TFC)+ Total Variable Cost (TVC)\boxed{\text{Total Cost(TC)}=\ Total\ Fixed\ Cost\ (TFC) +\ Total\ Variable\ Cost\ (TVC)}



Wize Tip
For the averages always divide the total by quantity (Q).

Average Fixed Cost  (AFC)= TFCQ\boxed{\text{Average\ Fixed\ Cost\ \ (AFC)} =\ \frac{TFC}{Q}}


Average Variable Cost  (AVC)= TVCQ\boxed{\text{Average\ Variable\ Cost\ \ (AVC)} =\ \frac{TVC}{Q}}


Average Total Cost (ATC)= TCQ\boxed{\text{Average\ Total\ Cost\ (ATC)} = \ \frac{TC}{Q}}


Average Total Cost (ATC)= AFC + AVC\boxed{\text{Average\ Total\ Cost\ (ATC)} =\ AFC\ +\ AVC}

Wize Tip
Marginal always has change in the formula.


Marginal Cost (MC)= ΔTCΔQ\boxed{\text{Marginal\ Cost\ (MC)} =\ \frac{ΔTC}{ΔQ}}


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Relationship Between Marginal Product and Marginal Cost

  • When marginal product (MP) is increasing, the marginal cost (MC) is
    decreasing
    . This is because as each additional worker becomes more productive (which is a good thing), the additional cost of each extra unit goes down.
  • When MP is decreasing, the MC is
    increasing
    . This is because as each additional worker becomes less productive (which is a bad thing), so the additional cost of each extra unit goes down
  • MP is at its maximum when MC is at its
    minimum

Relationship Between Average Product and Average Variable Cost

  • When average product (AP) is increasing, the average variable cost (AVC) is
    decreasing
    . This is because as the average worker gets more productive (which is a good thing), the average variable cost will go down.
  • When average product (AP) is decreasing, the average variable cost (AVC) is
    increasing
    . This is because as the average worker gets less productive (which is a bad thing), the average variable cost will go up.
  • AP is at its maximum when AVC is at its
    minimum

Relationship Between Marginal Cost and Average Variable Cost

  • When MC < AVC, it pulls the AVC
    down
    so AVC is
    decreasing
    . This is on the
    left
    side of the graph
  • When MC > AVC, it pulls the AVC
    up
    so AVC is
    increasing
    . This is on the
    right
    side of the graph
  • MC = AVC when AVC is at its
    minimum


Relationship Between Marginal Cost and Average Total Cost

  • When MC < ATC, it pulls the ATC
    down
    so ATC is
    decreasing
    . This is on the
    left
    side of the graph
  • When MC > ATC, it pulls the ATC
    up
    so ATC is
    increasing
    . This is on the
    right
    side of the graph
  • MC = ATC when ATC is at its
    minimum
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Average Fixed Cost

  • The only thing you need to know about average fixed costs (AFC) is that it is always decreasing.
  • This is because of the formula above. As the output (quantity) increases and we divide the fixed costs by a bigger and bigger number, the AFC falls.





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Example: Fixed and Variable Costs

Raphael makes pizzas at a local pizzeria. Here is the relationship between the number of workers and Raphael's output in a given day:
(i) Fill in the column of marginal products. Is the marginal product increasing or decreasing or both? Which law explains the decrease in marginal product?


Find the marginal product in each row using the formula Marginal Product (MP)= ∆Total Product(output)∆L\text{Marginal\ Product (MP)} =\ \frac{∆Total\ Product (output)}{∆L}. Marginal product is both increasing and then decreasing. Law of diminishing returns explain the eventual fall in MP.

(ii) A worker costs $100. Use this information to fill in the column for total cost. Fill in the column for average total cost (ATC) rounding any decimal to the nearest tenth.

The total cost is $200 in the first row where output is 0 so that must be the fixed cost (for things like rent). Add $100 for each additional worker in each row.

(iii) Now fill in the column for marginal cost rounding any decimal to the nearest tenth.

Find marginal cost in each row using the formula Marginal Cost (MC)= ΔTCΔQ\text{Marginal\ Cost\ (MC)}=\ \frac{ΔTC}{ΔQ}

(iv) Compare the column for marginal product and for marginal cost. Comment on the relationship linking these two variables. Why does the MC eventually rise?

MP and MC are inversely related. When MP is increasing. MC is decreasing and vice versa. MC eventually rises because MP eventually falls (law of diminishing returns).

(v) Is there a relationship between the marginal cost and the average cost? If yes, use the relationship to explain why the ATC curve is U-shaped.

Yes. When MC < ATC , ATC is decreasing (on the left side)
When MC > ATC, ATC is increasing (on the right side)
Therefore ATC is U-shaped

Practice: Fixed and Variable Costs

Raphael owns an Italian restaurant. The production function relating the number of meals served per day (Q) and the number of employees hired per day (L) is shown in the table. The marginal cost of serving a meal is lowest when Raphael increases the number of meals served per day from ___. The average variable cost of serving a meal is lowest when Raphael serves __ meals per day.

Extra Practice
When marginal product is rising, which of the following is true?
Which of the above curves is the marginal product curve?
Practice Question
Tony sells furniture. He pays $1,200 month to rent a warehouse and has a 3 year lease. Each day he has one friend Jerry whom he pays $100 to help him sell the furniture. Jerry sells on 200 units of furniture a month.
What is the fixed cost for one month?
What is the variable cost per month?
In the short-run capital is ___________ and labour is ___________ while in the long-run capital is ___________ and labour is ___________.
In the short run, a firm can vary
In the short run, a firm can vary
Factors of Production
The factors of production are
True/False:
When 
average total cost is falling, marginal cost must be
Suppose Thor's hammer makers increases its output from 20 to 25 hammers. Its total cost increase from $500 to $750. What is the the company's marginal cost of producing a hammer?
Fixed and Variable Costs
In the long run
In the short run
.
Practice: Marginal Product
John makes 2 pizzas and then we add Eric and he makes 1 pizza. Each of them is paid $10.