Short-run and long-run costs

Cambridge IGCSE / A‑Level Economics – Complete Syllabus Notes

1. Foundations (AS‑Level Topics 1‑6)

1.1 Scarcity, Choice & Economic Methodology

• Scarcity ⇒ limited resources, unlimited wants.
• Choices made using opportunity cost – the value of the next best alternative foregone.
• Methodology: positive (what is) vs normative (what ought to be) statements; ceteris paribus.

1.2 Factors of Production, Production Possibility Curve (PPC)

• Factors: land, labour, capital, enterprise.
• PPC shows maximum output combinations of two goods with fixed resources & technology.
• Points inside = inefficiency, on curve = productive efficiency, outside = unattainable.

1.3 Classification of Goods

Type	Characteristics
Normal	Demand rises when income rises.
Inferior	Demand falls when income rises.
Luxury	Income elasticity > 1.
Necessity	Income elasticity between 0 and 1.
Public good	Non‑rival & non‑excludable.
Common‑pool resource	Rival but non‑excludable.

2. Demand, Supply & Market Equilibrium (Topic 2)

• Law of demand: price ↑ ⇒ quantity demanded ↓ (ceteris paribus).
• Law of supply: price ↑ ⇒ quantity supplied ↑.
• Market equilibrium where Q_D = Q_S and P is the market price.

2.1 Elasticities

Elasticity	Formula	Interpretation
Price elasticity of demand (PED)	Δ%QD / Δ%P	|PED| > 1 = elastic; <1 = inelastic; = 1 = unitary.
Price elasticity of supply (PES)	Δ%QS / Δ%P	Higher PES ⇒ supply more responsive.
Income elasticity of demand (YED)	Δ%QD / Δ%Y	Positive = normal good; negative = inferior good.
Cross‑price elasticity (XED)	Δ%QD (good A) / Δ%P (good B)	Positive = substitutes; negative = complements.

2.2 Consumer & Producer Surplus

• Consumer surplus (CS) = area above price and below demand curve.
• Producer surplus (PS) = area below price and above supply curve.
• Dead‑weight loss (DWL) occurs when market is not at equilibrium (taxes, price controls, externalities).

3. Government Micro‑Intervention (Topic 3)

• Price ceilings (e.g., rent control) → shortage, DWL.
• Price floors (e.g., minimum wage) → surplus, DWL.
• Taxes shift supply curve left; incidence depends on elasticities.
• Subsidies shift supply curve right; opposite incidence effects.

4. Macro‑Economics Foundations (Topic 4)

• National income accounting: GDP = C + I + G + (X‑M).
• Circular flow: Households ↔ firms via factor and product markets.
• Aggregate demand (AD): total spending at each price level.
• Aggregate supply (AS): total output firms are willing to produce at each price level.
• Key macro variables: economic growth, unemployment (structural, frictional, cyclical), inflation (demand‑pull, cost‑push).

5. Economic Policies (Topic 5)

• Fiscal policy: government spending & taxation to influence AD.
• Monetary policy: interest rates & money supply via central bank.
• Supply‑side policies: improve LRAS (e.g., education, deregulation).
• Policy mix: coordination of fiscal & monetary tools.

6. International Trade & Finance (Topic 6)

• Comparative advantage ⇒ gains from trade.
• Protectionism: tariffs, quotas, subsidies – effects on consumer/producer surplus.
• Balance of payments (BoP): current + capital + financial accounts = 0.
• Exchange rate regimes: fixed, floating, managed float.
• Impact of exchange‑rate movements on imports, exports, and domestic inflation.

---

2. A‑Level Micro‑Economic Theory (Topic 7)

7.1 Utility & Marginal Utility

• Utility = satisfaction from consumption.
• Marginal utility (MU) = change in total utility from one extra unit.
• Law of diminishing marginal utility: MU falls as quantity consumed rises.
• Equi‑marginal principle: allocate budget so that MU_P/P_P = MU_Q/P_Q for maximum total utility.

7.2 Indifference Curves & Budget Constraint

• Indifference curve (IC): all bundles giving same utility.
• Higher IC ⇒ higher utility.
• Budget line: P_XQ_X + P_YQ_Y = I.
• Optimal consumption where highest attainable IC is tangent to budget line → MRS = P_X/P_Y.
• Income effect vs substitution effect when price changes.

7.3 Efficiency & Market Failure

• Productive efficiency: producing on the LRAC (lowest possible ATC).
• Allocative efficiency: P = MC (price equals marginal cost).
• Market failure occurs when market outcome is not efficient (externalities, public goods, information asymmetry, monopoly power).

7.4 Externalities & Public Goods

• External cost ⇒ MSC > MPC; external benefit ⇒ MSB > MPB.
• Welfare loss = area between MSC & MSB over the socially optimal quantity.
• Government solutions: Pigouvian taxes (for negative externalities), subsidies (for positive), direct provision of public goods.

7.5 Costs, Revenues & Profit (Core of the Original Notes)

7.5.1 Short‑run vs Long‑run

• Short‑run (SR): At least one input (usually plant size or capital) is fixed.
• Long‑run (LR): All inputs variable; firms can change scale, adopt new technology, or enter/exit the market.

7.5.2 Cost Classifications & Key Formulas

Cost	Definition	Formula	Relevant Horizon
Total Fixed Cost (TFC)	Costs that do not vary with output (e.g., rent, salaried managers).	–	SR only (becomes variable in LR)
Total Variable Cost (TVC)	Costs that vary directly with output (e.g., raw materials, hourly wages).	–	Both SR & LR
Total Cost (TC)	Sum of fixed and variable costs.	TC = TFC + TVC	Both SR & LR
Average Fixed Cost (AFC)	Fixed cost per unit of output.	AFC = TFC / Q	SR only
Average Variable Cost (AVC)	Variable cost per unit of output.	AVC = TVC / Q	Both SR & LR
Average Total Cost (ATC)	Total cost per unit of output.	ATC = AFC + AVC = TC / Q	Both SR & LR
Marginal Cost (MC)	Additional cost of producing one more unit.	MC = ΔTC / ΔQ	Both SR & LR
Long‑run Average Cost (LRAC)	Lowest possible ATC for each output when all inputs can be varied.	Envelope of SR ATC curves	LR only
Long‑run Marginal Cost (LRMC)	Additional cost of one more unit when plant size can also be adjusted.	LRMC = ΔLRAC / ΔQ	LR only

7.5.3 Short‑run Cost Curves

• AFC: Continuously falls as Q rises (fixed cost spread over more units).
• AVC & ATC: Typically U‑shaped.
  • Initially fall because of increasing marginal returns.
  • Rise after the point of diminishing marginal returns, reflecting higher MC.
• MC: U‑shaped; cuts AVC and ATC at their minimum points.

7.5.4 Long‑run Cost Curves

• LRAC: Envelope of all possible SR ATC curves, each representing a different plant size.
• Shape: Generally U‑shaped, reflecting three phases:
  1. Economies of scale – LRAC falls as output expands.
  2. Constant returns to scale – LRAC is flat.
  3. Diseconomies of scale – LRAC rises when the firm becomes too large.
• LRMC: Derivative of LRAC; meets LRAC at its minimum, mirroring the SR relationship.

7.5.5 Economies & Diseconomies of Scale

Source	Explanation (internal / external)	Effect on LRAC
Technical (internal)	Specialisation of labour & better utilisation of machinery.	LRAC falls
Managerial (internal)	Improved organisational structure, modern management techniques.	LRAC falls
Financial (internal)	Access to cheaper capital, lower borrowing costs.	LRAC falls
Marketing (internal)	Bulk buying, spreading advertising costs, stronger brand.	LRAC falls
External	Industry‑wide benefits – skilled local labour pool, specialised suppliers, infrastructure.	LRAC falls
Diseconomies of scale (internal)	Coordination problems, bureaucratic inefficiency, morale issues.	LRAC rises

7.5.6 Profit‑Maximising Conditions

• Short‑run:
  1. Produce where MC = MR.
  2. Continue operating while P ≥ AVC (price covers variable cost).
  3. If P < AVC, shut down immediately (pay only TFC).
• Long‑run:
  1. Choose scale so that LRMC = MR.
  2. In perfect competition, equilibrium satisfies P = LRAC = LRMC → zero economic profit (normal profit).

7.5.7 Example: Small Bakery

1. Fixed costs: rent £1 200/month, oven depreciation £300/month ⇒ TFC = £1 500.
2. Variable cost per loaf (flour, butter, hourly labour) = £1.20.
3. If the bakery produces 1 000 loaves:
   • TVC = 1 000 × £1.20 = £1 200.
   • TC = £1 500 + £1 200 = £2 700.
   • AFC = £1 500 / 1 000 = £1.50.
   • AVC = £1 200 / 1 000 = £1.20.
   • ATC = £2 700 / 1 000 = £2.70.
4. Marginal cost of the 1 001‑st loaf = £1.25 (slightly higher due to overtime wages).
5. If market price = £2.80, then MC < P ⇒ increase output until MC rises to £2.80 (profit‑maximising quantity).
6. Short‑run shutdown rule: if price fell to £1.10 (< AVC), the bakery would cease production.

7.6 Market Structures

Structure	Key Characteristics	Price & Output Decision
Perfect competition	Many firms, homogeneous product, free entry/exit, perfect information.	P = MR = MC; firms are price‑takers.
Monopoly	Single seller, unique product, high barriers to entry.	MR = MC determines output; P > MC (price‑setter).
Monopolistic competition	Many firms, differentiated products, low barriers.	Short‑run: MR = MC, P > MC; Long‑run: P = ATC (zero profit).
Oligopoly	Few large firms, inter‑dependent, may collude.	Outcome depends on game‑theoretic behaviour (e.g., Cournot, kinked demand).
Natural monopoly	Economies of scale over whole market; LRAC continuously falling.	Regulated price often set at P = ATC or P = MC (with subsidy).

7.7 Growth & Survival of Firms

• Organic growth: Internal expansion via reinvested profits, R&D.
• Inorganic growth: Mergers, acquisitions, strategic alliances.
• Vertical integration: Forward (distribution) or backward (inputs) integration.
• Horizontal integration: Acquiring rivals – can lead to market power.
• Cartels: Formal collusion to restrict output, raise price – illegal in many jurisdictions.
• Principal‑agent problem: Conflict of interest between owners (principals) and managers (agents); mitigated by performance‑related pay.

7.8 Firm Objectives & Pricing Strategies

• Objectives: profit maximisation, revenue maximisation, growth, market share, sales maximisation, corporate social responsibility.
• Price discrimination: Charging different prices for the same product based on willingness to pay (first‑, second‑, third‑degree).
• Limit pricing: Setting price low enough to deter entry.
• Predatory pricing: Short‑run losses to drive competitors out, then raise price.
• Bundling & versioning: Offering product packages or variants to capture consumer surplus.

---

3. Government Micro‑Intervention (Topic 8)

• Correcting market failure: Pigouvian taxes/subsidies, regulation, provision of public goods, tradable permits.
• Government failure: Information failure, capture, unintended consequences (e.g., rent‑control shortages).
• Equity & redistribution: Progressive taxation, means‑tested benefits, universal basic income, negative income tax.

4. Advanced Macro‑Intervention (Topic 9)

• Multiplier effect: ΔY = k·ΔG (or ΔI, ΔC) where k = 1/(1‑MPC).
• Money & banking: Money supply (M0, M1, M2), fractional reserve banking, interest‑rate transmission mechanism.
• Phillips curve: Short‑run trade‑off between inflation and unemployment; long‑run vertical at NAIRU.
• Policy mix & stagflation: Simultaneous high inflation and unemployment – challenges for policy makers.

5. International Macro Issues (Topic 10)

• Balance of payments: Current account (trade, services, income, transfers) + Capital & financial account = 0.
• Exchange‑rate regimes: Fixed (pegged), floating, managed float; effects on trade balance and inflation.
• Trade policies: Tariffs, quotas, import licences, export subsidies; welfare analysis of each.
• Economic integration: Free trade area, customs union, common market, economic and monetary union (e.g., EU).

---

6. Quick Revision Checklist (All Topics)

• Define and give examples of all key concepts (scarcity, PPC, elasticity, utility, market structures, etc.).
• Write the core formulas: GDP, AD, MPC, multiplier, cost curves, elasticity, etc.
• Sketch and label diagrams:
  • PPC, demand‑supply, tax incidence, consumer/producer surplus.
  • Indifference curves & budget line, marginal utility curve.
  • SR cost curves (AFC, AVC, ATC, MC) and LRAC envelope.
  • Market‑structure diagrams (price‑setter vs price‑taker, kinked demand).
  • AD‑AS, Phillips curve, BoP accounts.
• Explain the logic behind each policy tool (e.g., why a Pigouvian tax corrects a negative externality).
• State the profit‑maximising rules for SR and LR, and the shutdown/exit criteria.
• Identify internal and external economies of scale and relate them to the shape of LRAC.
• Connect every point to the Cambridge key concepts: margin (MC, MR), efficiency (productive & allocative), time (SR vs LR), and equity (distribution of income, redistribution policies).
• Practice past‑paper questions that require:
  • Calculations (elasticities, multiplier, cost per unit).
  • Evaluation (advantages & disadvantages of a policy).
  • Application of theory to real‑world examples (e.g., Uber and market structure, carbon tax and externalities).

7. Key Concepts Summary

• Margin: Decisions based on the next unit – MC, MR, MU, marginal product.
• Efficiency: Productive (lowest cost) & allocative (P = MC); illustrated by LRAC and MC‑intersection points.
• Time: Distinguishes SR (fixed inputs) from LR (all inputs variable) and underpins cost behaviour and firm‑entry/exit decisions.
• Equity: Distributional impact of policies; assessed via progressive taxes, subsidies, and welfare analysis.