Fixed & Variable Cost and Short & Long Run Cost

Concept of costs

A firm produces goods it has to incur expenses. Such expenses are payments to labor, land owners, capital, purchase of raw materials, fuels etc. Cost is concerned with financial aspect of production. There are different types of cost in economics. Among them, the concept of fixed and variable costs are discussed.

Fixed Cost

The expenses made for setting up the production plant are the fixed cost. It doesn’t change in the short time period and also doesn’t depend on the quantity of production. For e.g.: cost of machinery, building, managerial team etc. are the fixed cost. It is also known as overhead cost or supplementary cost.

Variable Cost

Variable cost is the one which changes along with the quantity production. For e.g. expenses for raw material, energy use, daily wage labor etc. are the variable cost. Thus, variable cost is those which vary with variation in the total output.

Short Run

The short run is a period of time in which one factor of production is fixed so that the firm can change its output by changing the variable factors only. The firm in the short run cannot alter fixed inputs because it is technically difficult to do so in the short period. If the firm wants to expand then it will cost high.

Long Run

The long run is a period of time in which all factors are variable. In the long run, the inputs don't remain fixed and the firm can take decision easily. The firm can change its output by altering the firm’s plant size, altering capital input or even changing the plant size.

Short-Run Cost Curves

Total Fixed Cost (TFC)

Total fixed cost are fixed cost which must be incurred by a firm in the short run, whether the output is small or large. They are those cost, which is fixed in volume for certain given output. It includes expenditure made on land, building, machinery, administrative expenses, insurance fee, and so on.

Total fixed cost (TFC) is explained with the help of the table.

The above table shows that total fixed cost remains the same at every level of income. The cost is Rs.10 when the output unit is 0. When the output increases from 0 to 1, the cost is still the same i.e. Rs.10. Similarly, the output goes on increasing and reaches to 4 units but the cost is fixed to Rs.10. It can be shown from the following figure:

The above figure shows, TFC curves represent the total fixed cost curve, which is parallel to the horizontal axis as it remains constant at a different level of output. Here, the TFC is fixed in OP when the level of output increases from OQ, OQ₁, OQ₂ and OQ₃.

Total Variable Cost (TVC)

Total variable cost is those cost which is incurred on the employment of variable factors of production whose amount can be altered in the short run. TVC is the cost incurred on the variable factor like raw material, energy supply, direct labor etc.
TVC can be explained with the help of the following table:

The above table shows that TVC is 0 when the output is 0. As the production began, TVC increases significantly in the 1^st phase due to the inefficiency of management, labor forces or operation module of machinery and equipment. After this, TVC rises up slowly which is seen up to 4 units of production in the given table. After 4 units, TVC again increases. So, as a result of heavy maintenance cost, TVC rises up rapidly.

The above figure shows the total variable cost curve. TVC is zero at starting when no output is produced. When the output rises, the TVC curve forms an inverse shape due to the operation of a law of variable proportions. At a low level of output and again rises more than the rise in output. Later on, TVC rises less than the rise in output and again rises more than output.

Total Cost (TC)

Total cost is the sum of total fixed cost (TFC) and total variable cost (TVC) in the short run. It gives the total cost of production of the firm in the short run. The total cost of production changes with the change in total variable cost as it changes with the level of output.
i.e. TC = TFC + TVC

Total cost can be explained with the following table:

The above table shows that the total fixed cost remains constant with every increase in output. The total variable cost increases with the increase in the level of output. Total cost (TC) is obtained by adding TFC and TVC. TC increases with the every increase in output pushed by TVC. Hence, TC and TVC has a positive relation.
It can be shown with the help of the following figure:

The above figure shows that TC, TVC, and TFC curve represents the total cost curve, total variable cost curve, and total fixed cost curve respectively. TC curve starts from the point where TFC curve starts. But when output rises, TC rises since variable costs come into operation. So, TC curve takes the shape of TVC curve.

Short-Run Average Cost Curves

Average Fixed Cost (AFC)

Average Fixed Cost (AFC) is defined as total fixed cost divided by the level of output produced. It is the per unit production of fixed cost. Thus,

AFC = \(\frac{TFC}{Q}\)

Where,

AFC = Average Fixed Cost

TFC = Total Fixed Cost

Q = Level of output

As a fixed cost remains constant dividing by an increasing output would gradually reduce the average fixed cost. It can be shown from the following figure:

In the above figure, AFC is the average fixed cost. AFC curve drops lower as the output expands, when AFC becomes very large it approaches the horizontal axis but never touches the x-axis.

Average Variable Cost (AVC)

Average Variable Cost is defined as the total variable cost divided by the level of output produced. Thus,

AVC = \(\frac{TVC}{Q}\)

Where,

AVC = Average Variable Cost

TVC = Total Variable Cost

Q = Level of output

The average variable cost will generally fall as the output increases. It can be explained with the help of the following figure:

In the figure, AVC represents Average Variable Cost.It slopes downward, in the beginning, reaches a minimum point and rises upward thereafter.

Average Total Cost (ATC)

Average total cost is defined as the total cost divided by the level of output produced. It can also be defined as the sum of average fixed cost and average variable cost. Symbolically,

ATC = \(\frac{TC}{Q}\)

= \(\frac{TFC}{Q}\) + \(\frac{TVC}{Q}\) = AFC + AVC

= AFC + AVC

Where,

ATC = Average Total Cost

AFC = Average Fixed Cost

AVC = Average Variable Cost

TC = Total Cost

Q = Quantity produced

Average total cost gives us the total cost per unit of production. It can be shown in the figure:

In the above figure, ATC represents Average Total Cost. In the beginning, ATC declines and reaches its minimum point as the utilization of plant reaches maximum. Thereafter ATC starts rising due to diseconomies of scale and it takes a 'U' shape.

Marginal Cost (MC)

Marginal cost is the increase or decrease in total production cost if output is increased by one more unit.Thus,

MC = \(\frac{ΔTC}{ΔQ}\)

Where,

MC = Marginal Cost

ΔTC = Change in Total Cost

ΔQ = Change in output

The marginal cost of the second unit of output is obtained by subtracting the total cost of one unit from two unit of output produced.

MC₂ = TC ₂ - TC₁

The marginal cost curve can be shown from the following figure:

In the above figure, the marginal cost first falls, reaches minimum and thereafter increases. Thus MC curve also first slopes downward reaches the minimum and rises thereafter.

Relation between AC, AFC, AVC and MC

The relation between AC, AFC, AVC and MC can be shown from the following figure:

In the above figure, AFC falls continuously approaching both the axes. In the beginning,AVC falls, reaches minimum and then starts rising at the fourth unit of output. When AVC is at minimum MC equals AVC. When AFC approaches the horizontal axis, AVC approaches ATC. Thus ATC = AFC + AVC. When ATC is at a minimum, MC = ATC. When both AVC and ATC curves are falling MC curve lies below them. It lies above them when they are rising therefore, MC cut AVC and AC respective,y from below.

(Jha, Bhusal and Bista)(Karna, Khanal, and Chaulagain)

Bibliography

Jha, P.K., et al. Economics II. Kalimati, Kathmandu: Dreamland Publication, 2011.

Karna, Dr.Surendra Labh, Bhawani Prasad Khanal and Neelam Prasad Chaulagain. Economics. Kathmandu: Jupiter Publisher and Distributors Pvt. Ltd, 2070.