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Variable Costs.docx

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University of Manitoba
ECON 1010
Sarrah Vakili

Variable Costs Variable costs are costs that vary directly with output. Examples of variable costs include the costs of intermediate raw materials and other components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear. Average variable cost (AVC) = total variable costs (TVC) /output (Q) Average Total Cost (ATC or AC): Average total cost is simply the cost per unit produced Average total cost (ATC) = total cost (TC) / output (Q) Marginal Cost Marginal cost is the change in total costs from increasing output by one extra unit. The marginal cost of supplying an extra unit of output is linked with the marginal productivity of labour. The law of diminishing returns implies that the marginal cost of production will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases. Worked example of short run production costs A simple numerical example of short run costs is shown in the table below. Fixed costs are assumed to be constant at £200. Variable costs increase as more output is produced. In our example, average cost per unit is minimised at a range of output between 350 and 400 units. Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1). Short Run Cost Curves When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Average total cost continues to fall until output Q2 where the rise in average variable cost equates with the fall in average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the short run. This is known as the output of productive efficiency. A change in variable costs A rise in the variable costs of production leads to an upward shift both in marginal and average total cost. The firm is not able to supply as much output at the same price. The effect is that of an inward shift in the supply curve of a business in a competitive market. An increase in fixed costs has no effect at all on variable costs of production. This means that only the average total cost curve shifts. There is no change at all on the marginal cost curve leading to no change in the profit maximising price and output of a business. The effects of an increase in the fixed or overhead costs of a business are shown in the diagram below. Short Run and Long Run Production The concept of a production function: The production function is a mathematical expression which relates the quantity of factor inputs to the quantity of outputs that result. We make use of three measures of production / productivity.  Total product is simply the total output that is generated from the factors of production employed by a business. In most manufacturing industries such as motor vehicles, freezers and DVD players, it is straightforward to measure the volume of production from labour and capital inputs that are used. But in many service or knowledge-based industries, where much of the output is “intangible” or perhaps weightless we find it harder to measure productivity  Average product is the total output divided by the number of units of the variable factor of production employed (e.g. output per worker employed or output per unit of capital employed)  Marginal product is the change in total product when an additional unit of the variable factor of production is employed. For example marginal product would measure the change in output that comes from increasing the employment of labour by one person, or by adding one more machine to the production process in the short run. The Short Run Production Function The short run is defined in economics as a period of time where at least one factor of
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