Fixed and variable costs

Let's consider a firm supplying tablet computers. The firm produces tablets in-house. The capital and land needed for production at the firm include an administrative head office and a manufacturing site. These are fixed factors of production-- in the short-run, they cannot be changed. After all, it takes time to expand buildings and develop new production facilities.

Let's assume the firm pays an annual rental charge for the use of buildings and machinery. In the short-run, the firm's fixed factors represent a fixed cost. A fixed cost does not change with output. But the firm can squeeze more staff into its existing buildings to help increase output without altering the size of buildings or the amount of equipment.

The firm can produce more tablet computers by increasing its use of variable factors, such as labor and raw materials. Increasing output will mean more work needs to be done. Additional forklift truck drivers will be needed to move raw materials. Similarly, more engineers will be needed to service equipment and provide adequate maintenance. More administrative staff will be required in the head office to manage the increasing flow of labour. And, of course, the amount of raw materials used will also increase.

If the firm increases its variable inputs, output will increase. In the short-run, the variable costs will increase while our fixed costs remain unchanged. Fixed cost is constant-- it's the same at all levels of output, so it's represented by a horizontal straight line on the diagram. Here we are showing costs on the vertical axis, and quantity produced per week on the horizontal axis.

But average fixed cost will change as output increases. Average fixed cost must fall as output rises. As output is increased, the fixed cost is spread over larger and larger numbers of units. The average fixed cost will get smaller and smaller. So the average fixed cost curve looks like this.

Variable costs increase with output. If we assume that this firm experiences increasing returns to variable factors at low levels of output and decreasing returns at high output, then we can draw an average variable cost curve which has a U shape. Now we have a U shape cost curve for average variable cost, and a cost curve for average fixed cost. Now we can add these two curves together to produce an average total cost curve which we'll label AC for our average cost curve.

Since we're adding together two cost curves, we must sum vertically. Average fixed cost plus average variable cost gives average total cost, more simply called average cost. So at Q1, average variable cost is equal to AVC1, to which we add the average fixed cost AFC1 to give a value of average cost, AC1. AVC1 plus AFC1 equals AC1.

Now we have one point on the firm's average cost curve. Similarly, for Q2 we have AVC2 plus AFC2 equals AC2. The same reasoning applies for Q3 and Q4. So we can repeat this process for all possible levels of output and so derive the average cost curve.

At low levels of output, average cost is falling. This is because, firstly, average fixed cost falls as output is increased. And secondly, average variable cost fall due to increasing returns to the variable factors being used by the firm.

At higher output levels, average variable cost rises due to the effect of diminishing returns to the variable factors which outweigh the decrease in average fixed cost. The average cost curve takes the shape of a U, falling as output is increased when output is low, and rising as output continues to be increased at high output levels. Because economists expect that the same kind of thing will happen in all, or at least most, production processes, the U-shaped average cost curve is the model that economists use in analysing the short-run behaviour of firms' costs.