Cost Curves and Economics

Cost Curves and Economics






Question 1

We use seven cost curves to make decisions in economics.

Total cost curve: Firms produce at the lowest possible total cost for the produced quantity.

Total cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

Fixed Costs (FC) – These are costs that have to be met no matter the production level.

Variable costs (VC) – These change with output produced

Marginal Costs (MC) – This is the additional cost of producing of one extra unit.

MC = σTC

MC = dTC/dQ = d(FC+VC)/dQ = dVC/dQ

MC is the gradient of the VC or TC implying that the magnitude of change in cost depends on variable costs.

Marginal costs increase as production increases in a law called diminishing returns. This continues to a point where the production of one more unit is untenable since the cost is greater than the revenue

On the other hand, Average fixed costs will always decrease with an increase in production but since marginal cost of production eats into the gain, the firm might be losing out at the lowest AFC.

Average costs.

AC = TC/Q = (FC+VC)/Q = FC/Q + VC/Q = AFC + AVC

AFC decrease as production rises while AVC doesn’t.

AVC is dependent to the MC.

The MC intercepts both AFC and AVC at their minimum points. This is because if marginal cost goes below the average cost, the average cost must be decreasing. Whenever MC<AC, the AC will fall regardless of whether MC is rising or not.

When diminishing returns to scale kick in at Q1, marginal cost curve begins to rise while ATC begins to fall until we get to point Q2 where an increase in AVC is equal to the decrease in AFC. In the short run, the output Q2 is lowest point of the average total cost and the output Q2 is known as the ‘productive efficiency output’ (Black 2002).

Question 2

Figures 1 and 2 prove that no economic profit is possible for firms in a perfectly competitive market, any gain in profits a firm makes by alterations in the equilibrium price or quantity by a single firm will be offset by a loss in efficiency, price or quantity produced. The equilibrium in the long run will always remain at the point where MR = MC.

In choosing the best production mix, we are assuming that the firm’s management is rational in making the decisions they make and that consumers are also rational and will choose the product that best suits them at the best suitable prices.

Profit maximization occurs at the output level which corresponds with the equality point between marginal costs and marginal revenue given that a profit maximizing firm operates at a point where total revenue less total cost is highest. In the Long run the firm will have to explore different options.

Output Q1 with Average cost 1

Output Q2 with AC3

Output Q3 with AC3

Output Q4 with AC2

All the production combinations above the LRAC are attainable but not realistic, while all the combinations below it are unrealistic for a firm focused on profit maximisation.

At Q1 the firm is producing but at a level below potential, given the resource mix present. As the firm takes advantage of economies of scale and becomes more efficient, it will start enjoying increasing returns to scale. As firms expand, the economies of scale will come from factors such as more availability of cheap credit, more specialization of its labour, more discounts and bargaining power among others. The point Q2 is referred to as minimum efficient point, which is the point at which a firm has exhausted its economies of scale.

Over a certain range of output (Q2 – Q3), the Average cost could be constant but after some time, the benefits brought about by the economies of scale will start getting eroded. The erosion will arise from factors such as rising administrative costs, increased investments in capital goods such as space and equipment. The management will also start meeting challenges and this and other factors will cause the average cost to rise from here. The returns to scale will also start to decrease resulting to diseconomies of scale.

Question 3: The Perfect Market

A perfect market or perfect competition is hypothetically a market where competition is at its best. The neo-classical theory proffered that this is the market form that would yield the outcomes that would best suit all stakeholders; society, consumers and producers. The competitive market theory operates under certain assumptions.


Top of Form

Baumol, W & Blackman, S 2001, Perfect markets and easy virtue: business ethics and the invisible hand, Cambridge, Mass., USA, B. Blackwell.

Top of Form

Cassidy, J 2009, How markets fail: the logic of economic calamities, New York, Farrar, Straus and Giroux.

Black, J 2002, Perfect Markets and Economics today,Top of Form Cambridge, MA, MIT Press.

Miller, R 2001, Paving Wall Street: experimental economics and the quest for the perfect market, New York, Wiley.

Bottom of Form

Bottom of Form