Cost Curves

Imagine you own a company, and you are to determine the costs you face. You will begin by looking at the company's total cost and dividing it between the fixed cost you have which you can't avoid and some other variable costs that you can sometimes avoid. After it, you graph the cost curves for each. Do you think the shape of these cost curves is the same in the short and long run?

Did you know that companies use their cost curves to minimize their expenses and maximize profit? If you want to find out how, get to the bottom of this article!

We've covered all there is to know about cost curves!

The Shape of Cost Curves

The shape of cost curves depends on the type of cost a company might face.

The labor and capital a company employ determine how much it costs to produce its product.

Nevertheless, the shape of the cost curves is relatively the same.

When analyzing the shape of the curve displaying the entire cost of production. It is helpful for a company to begin by dividing the total costs into two categories: fixed costs, which are expenses that cannot be altered in the short run, and variable costs, which are costs that may be controlled.

The shape of fixed costs is a straight line. In contrast, the shape of the variable costs of a company is U-shape.

When the firm faces a U-shape cost curve, the cost of production initially decreases until it reaches a point where it begins to increase.

Below we discuss the shape of each cost curve in great detail.

Total Cost Curves

Total cost curves represent the aggregate of all the expenses a company faces when producing a certain quantity of product.

The formula for total cost is as follows:

\(\hbox{TC}=\hbox{FC}+\hbox{VC}\)

Fixed costs include costs such as the costs of a building lease and machinery used during the production process. Within reason, fixed costs do not change as if output increases or decreases.

In other words, regardless of the company's production level, the company will still face fixed costs.

Variable costs include costs such as the cost of labor and raw materials. These costs do change with the level of output.

Fig. 1 - Total cost curve

Figure 1 illustrates the total cost curve. Notice that in the diagram in Figure 1, there are also fixed and variable costs. That's because the total cost curve consists of these two main curves.

• Because the total cost is equal to the sum of the variable cost and the fixed cost, the curve representing the total cost is similar in shape to the curve representing the variable cost.
• However, the total cost curve is at a higher level because of the fixed cost. The fixed cost will add a fixed amount to each variable cost. So for every change in the VC, the shape of the total cost will follow, plus the amount of the fixed cost.

Notice also that the fixed cost is a horizontal line, and that's because fixed costs remain the same regardless of the amount of output that is generated.

Initially, the slope of the total cost is flatter. That's because a company's total cost increases at a decreasing rate. As employees can specialize in their tasks and become more efficient, producing certain goods is initially cheaper.

After some point, the slope of the total cost curve becomes steeper, meaning that a company's production cost increases. That's because the company faces diminishing marginal returns. Meaning that additional workers or capital employed in the production process is becoming less efficient, leading to an increase in the total cost that a company faces.

Short Run Cost Curves

Short-run cost curves refer to curves that represent the amount of cost a firm faces during the short run. Short run is characterized by having the amount of one of the factors of production function kept constant. In contrast, the number of other factors may change.

• Production elements such as land and equipment are similar when looking at costs over the near term.
• On the other hand, other aspects of production, such as the amount of labor and capital, are subject to change.

As a result, a company may raise its overall productivity by growing its capital or labor. This is where the difference between short-run and long-run cost curves lies.

There is no such thing as a fixed element in terms of costs over the long run. Over a longer time, factors such as contractual wages, the overall price level, and other pricing aspects are adjusted in response to the status of the economy. In the near term, adjusting some of the fixed production factors is impossible.

Fig 2. - Short-run cost curves

Figure 2 shows the short-run cost curves that a company faces. In the short run, the costs that are considered for a company include marginal cost (MC), average total cost (ATC), average fixed cost(AFC), and average variable cost (ATC).

As the AFC of a company decreases with the increase in production, that is that more output level covers the fixed cost, yet the ATC curve still increases. When the AVC begins to increase, it also causes the ATC curve to increase.

Point A is the point where marginal cost and average variable cost intersect. Point A is the lowest possible level of the average variable cost. This is the inflection point where output lower than this experiences decreasing marginal costs, and output greater will be subject to increasing marginal costs.

Point B is the point where marginal cost intersects the average total cost. At this level, the total cost is at its lowest level. At this point, marginal costs are going up at an increasing rate, while fixed costs are going down at a decreasing rate. This point is the perfect balance of cost reduction between those two changing costs.

Long Run Cost Curves

Long-run cost curves show the cost that a company faces in the long run for producing a certain amount of output.

While in the short run, some of the factors of production are fixed, meaning that the firm isn't flexible in changing these factors, their cost is also fixed.

On the other hand, the cost faced by a company, in the long run, is entirely variable. That's because all factors of production during the long run are to be variable.

Fig. 3 - Long-run cost curves

Figure 3 shows the long-run cost curve. The long-run cost curve is the long-run average total cost curve which consists of many short-run average total costs (ATC).

The short-run ATC shows a firm's cost when producing that amount of output in the short run with a certain combination of variable cost and fixed cost.

Over the long run, a firm may produce different outputs through various combinations of fixed and variable costs.

This is why the long-run cost curve consists of many short-run ATC. The three different short-run ATC curves represent the potential large-scale change in production such as purchasing a larger factory.

Notice that the shape LATC curve initially decreases from point A to point C as the firm's output increases. On the other hand, the LATC begins to increase from point C to point B.

That's because of diminishing marginal returns. As the company adds more inputs to the production process, these inputs become less efficient at generating output. At the same time, the cost that the company faces increases.

Point C is the number of output the firm has to produce to minimize cost over the long term.

Average and Marginal Cost Curves

Average and marginal cost curves are curves that point to the average and marginal cost a firm faces.

The average cost is the cost of producing one unit. The average cost is calculated by dividing the total cost by the total output.

Like the total cost, the average cost consists of the average fixed and marginal costs.

Average variable cost (AVC) is the variable cost per unit of production.

Marginal cost refers to the additional cost of producing one more unit or service.

Fig. 4 - Average costs

Figure 4 shows the curves of average costs.

Notice that the average fixed cost per unit produced decreases. That's because as a firm produces more output while the fixed cost remains the same, the fixed cost will decrease per unit of production.

On the other hand, the average variable cost (AVC) increases with the increase in output. That's because as the production volume increases, a firm's variable cost increases as well.

The average total cost is U shaped; it initially decreases with the decline of AFC and begins to increase again as the AVC increases.

Fig. 5 - Marginal cost curve

Figure 5 shows the marginal cost curve. The marginal cost initially decreases up to a certain point, where it also begins to increase. That's because of the diminishing marginal returns of a firm—the production at a firm increases at a much slower rate than the rise in its marginal cost.