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)
Microeconomic Decision‑Makers – Firms' Costs, Revenue and Objectives
Key Definitions of Production Costs
Understanding the different types of costs is essential for analysing a firm’s behaviour and its decisions about output, pricing and profitability.
Total Cost (TC) – the overall cost incurred in producing a given level of output. It comprises both fixed and variable components.
Fixed Cost (FC) – costs that do not vary with the level of output in the short run (e.g., rent, salaries of permanent staff).
Variable Cost (VC) – costs that change directly with the quantity of output produced (e.g., raw materials, hourly wages).
Average Total Cost (ATC) – the cost per unit of output, calculated by dividing total cost by the quantity produced.
Average Fixed Cost (AFC) – the fixed cost per unit of output.
Average \cdot ariable Cost (A \cdot C) – the variable cost per unit of output.
Mathematical Relationships
The following equations express the relationships between the different cost concepts. LaTeX notation is used for clarity.
Cost Concept
Formula
Explanation
Total Cost (TC)
\$TC = FC + VC\$
Sum of fixed and variable costs for a given output level.
Average Total Cost (ATC)
\$ATC = \frac{TC}{Q}\$
Cost per unit, where \$Q\$ is the quantity of output.
Average Fixed Cost (AFC)
\$AFC = \frac{FC}{Q}\$
Fixed cost spread over each unit of output.
Average \cdot ariable Cost (A \cdot C)
\$A \cdot C = \frac{VC}{Q}\$
Variable cost per unit of output.
Relationship between averages
\$ATC = AFC + A \cdot C\$
Average total cost is the sum of average fixed and average variable costs.
How Costs Behave with Output
At very low levels of output, AFC is high because the fixed cost is spread over few units.
A \cdot C typically falls as output rises, reflecting increasing returns to the variable factor (e.g., better utilisation of machinery).
Beyond a certain output, A \cdot C may start to rise due to diminishing returns to the variable factor.
The ATC curve is U‑shaped, reflecting the combined effect of falling AFC and the U‑shaped A \cdot C.
Suggested diagram: U‑shaped Average Total Cost (ATC) curve showing its components AFC and A \cdot C, with the typical downward‑sloping AFC and U‑shaped A \cdot C.
Implications for Firm Objectives
Firms compare their total revenue (TR) with total cost (TC) to determine profitability:
\$\text{Profit} = TR - TC\$
If TR > TC, the firm makes a profit and may consider expanding output. If TR < TC, the firm incurs a loss and may need to reduce output or exit the market in the long run.
In the short run, a firm will continue to produce as long as its revenue covers its variable costs (TR ≥ VC), even if it does not cover total costs, because fixed costs are sunk in the short run.