Definitions of costs of production: total cost (TC), average total cost (ATC), fixed cost (FC), average fixed cost (AFC), variable cost (VC), average variable cost (AVC)

Micro‑economic Decision‑Makers – Firms’ Costs, Revenue and Objectives (Cambridge 3.6)

1. Key Definitions of Production Costs

• Total Cost (TC): the monetary cost of producing a given level of output.
  TC = FC + VC
• Fixed Cost (FC): costs that do not vary with output in the short run (e.g., rent, insurance, salaries of permanent staff).
• Variable Cost (VC): costs that vary directly with the quantity produced (e.g., raw materials, hourly wages, electricity used in production).
• Average Total Cost (ATC): cost per unit of output.
  ATC = TC ÷ Q
• Average Fixed Cost (AFC): fixed cost spread over each unit of output.
  AFC = FC ÷ Q
• Average Variable Cost (AVC): variable cost per unit of output.
  AVC = VC ÷ Q

2. Core Formulae and Relationships

3. Behaviour of Cost Curves with Output (Q)

1. AFC falls continuously as output rises because the same fixed cost is spread over more units.
2. AVC usually falls at low output (increasing returns to the variable factor) and then rises after a certain point (diminishing returns). The curve is therefore U‑shaped.
3. The combination of a falling AFC and a U‑shaped AVC yields a U‑shaped ATC curve.
4. TC rises with output; its shape mirrors the AVC curve but is shifted upward by the fixed‑cost component.

4. Economies and Diseconomies of Scale (ATC Diagram)

• Economies of scale: when ATC falls as output expands because the firm can spread both fixed and some variable costs over a larger output (e.g., bulk buying, specialised machinery).
• Diseconomies of scale: when ATC begins to rise after a certain output level because coordination problems, over‑utilisation of equipment, or higher input prices outweigh the benefits of scale.

In the ATC diagram this appears as a downward‑sloping segment (economies) followed by an upward‑sloping segment (diseconomies), giving the classic U‑shape.

5. Diagrammatic Interpretation – What to Draw in the Exam

6. Revenue Concepts (Required by the Syllabus)

• Total Revenue (TR): money received from selling output.
  \$TR = P \times Q\$ where P is the market price.
• Average Revenue (AR): revenue per unit of output.
  \$AR = \frac{TR}{Q} = P\$

  
  In perfect competition AR equals the market price and the firm’s demand curve is perfectly elastic.

7. Firm Objectives (Cambridge Syllabus)

• Survival: covering at least variable costs in the short run; avoiding bankruptcy in the long run.
• Profit maximisation: the default objective in the “short‑run profit‑maximisation” model; the firm chooses output where MR = MC.
• Growth: increasing market share or output over time; often linked with economies of scale.
• Social‑welfare / non‑profit goals: relevant for public‑sector or charitable organisations; not required for the standard profit‑maximisation analysis but worth mentioning.

In the exam, unless the question states otherwise, assume the firm is a profit‑maximiser operating in a perfectly competitive market.

8. Profit‑Maximisation, Break‑Even and Short‑Run Shutdown Rule

Profit (π) is the difference between total revenue and total cost:

\$\pi = TR - TC\$

• Break‑even point: where TR = TC (π = 0). The firm covers all its costs but makes no economic profit.
• Profit‑maximising output (short‑run): produce where MR = MC. In perfect competition MR = AR = P, so the rule reduces to P = MC.
• Short‑run shutdown rule: continue producing as long as revenue covers variable cost.
  \$TR \geq VC \quad\text{or equivalently}\quad AR \geq AVC\$

  
  If the inequality fails, the firm should shut down temporarily because fixed costs are sunk in the short run.

9. Worked Example (IGCSE / A‑Level style)

Analysis:

• AR = £5 (price is constant in perfect competition).
• Compare AR with AVC:

  • Q = 10: AVC = £15 → AR < AVC → shut‑down.
  • Q = 30: AVC = £10 → AR < AVC → still shut‑down.
  • Only if AVC fell below £5 would the firm stay open in the short run.

• Break‑even would occur where TR = TC. In this data set TR never reaches TC, so the firm cannot break even at the given price.

10. Summary Checklist for Exam Answers

• State correct definitions of TC, FC, VC, ATC, AFC, AVC, TR and AR.
• Write the five key formulas and the relationship ATC = AFC + AVC.
• Explain the typical shape of each cost curve and why AFC always falls.
• Describe economies and diseconomies of scale and link them to the ATC curve.
• Draw a clear diagram showing TC, ATC, AFC and AVC (and optionally MC); label the ATC minimum, the AFC‑AVC vertical distance, and the break‑even point if required.
• State the profit formula π = TR – TC, the break‑even condition (TR = TC) and the short‑run shutdown rule (TR ≥ VC or AR ≥ AVC).
• Identify the assumed firm objective (profit maximisation) and note alternative objectives for completeness.
• Use a brief numerical example (like the table above) to illustrate calculations of costs, revenues, and profit/loss.