Cost concepts

The essentials

A firm's total cost (TC) has two parts. Total fixed cost (TFC) does not change with output (rent of the factory, salary of permanent staff, interest on capital); it must be paid even at zero output. Total variable cost (TVC) changes with output (raw materials, wages of casual labour, electricity for machines). TC = TFC + TVC.

Key points

• AFC = TFC ÷ q. AFC falls continuously as output rises; the curve is a rectangular hyperbola.
• AVC = TVC ÷ q. AC (ATC) = TC ÷ q = AFC + AVC.
• Marginal cost: MC = ΔTC ÷ ΔQ = ΔTVC ÷ ΔQ (TFC does not change).
• AVC, AC and MC are U-shaped in the short run because of the law of variable proportions.
• MC cuts AVC and AC at their minimum points from below.
• The vertical gap between AC and AVC equals AFC; it narrows as output rises but never becomes zero.
• The minimum of AVC lies to the left of (at a lower output than) the minimum of AC.
• TVC and TC curves are parallel, separated by TFC.

Exam tips

• From a TC table, TFC is the cost at zero output; subtract it to get TVC.
• To get MC from AC values, first convert to TC (AC × q) and then take the difference.

Common mistakes

• Including TFC change in MC; TFC never changes in the short run.
• Thinking AFC is U-shaped. It only falls.
• Subtracting AC values to get MC; MC comes from the change in total cost.