Question

5) Distinguish between fixed, variable and total costs.

6) Explain the difference between average and marginal costs.

Answer 1

5) In the short run, the cost function, which is mathematically a (polynominal, usually) function of quantity, comprises two kinds of cost, fixed and variable.

The fixed cost is the cost of capital, amount of which is fixed in the short run. One can't change the capital part of production input in the short run, such as the machinery and infrastructure (building, etc). That is why, in the short run, the quantity of capital is fixed, and so is its cost. In the long run however, there is no fixed cost, as there is enough time and production experiences to vary and adjsut the capital.

The variable cost in the short run is the cost of inputs which may vary even in the short run, such as labor and raw-materials. It varies in the long run as well, along with variations in the short run-fixed costs (capital costs). As inputs may vary in the short run, so does its costs.

Total cost is the sum of total variable costs and total fixed costs, ie . In the short run, the total cost varies the same as the variable costs, as the fixed cost is constant in the short run. In the long run however, there are no such fixed cost.

6) The average cost is the total cost per output, ie , while the marginal cost is the change in total cost per unit change in output, ie . In usual microeconomic discourse in the short run, the average cost decreases and then increases, providing a minimum average cost of the firm, whereas the marginal cost may decrease initailly, but increases for most of the output. Marginal cost touches average cost at its minimum. The average cost needs fixed cost in calculation, while marginal cost doesn't, as and or , as the fixed cost doesn't change in the short run.

As can be seen, the relevant marginal cost is above the variable cost. While marginal cost of the firm is the supply curve of the firm, the average cost is what decides the profit/loss/no-profit-no-loss of the firm.