Fixed, variable, total, average and marginal cost

In the short run at least one factor of production is fixed (usually capital — the factory). In the long run all factors are variable. The short run and long run are defined by that, not by any number of months.

• Fixed costs (FC) — do not vary with output: rent, business rates, insurance, the salaried manager. They exist even at zero output. Sunk costs are fixed costs that cannot be recovered on exit (a bespoke advertising campaign) and are a major barrier to entry.
• Variable costs (VC) — vary directly with output: raw materials, energy, piece-rate labour.
• TC = FC + VC  ·  AC = TC ÷ Q  ·  AFC = FC ÷ Q (always falls as Q rises — "spreading the overheads")  ·  AVC = VC ÷ Q
• MC = ΔTC ÷ ΔQ — the cost of one more unit. Because fixed costs do not change, MC = ΔVC ÷ ΔQ too.

Your turn — average total cost

Your turn — marginal cost

The law of diminishing returns

The law of diminishing (marginal) returns is a short-run law. As successive units of a variable factor (labour) are added to a fixed factor (a kitchen, a field), eventually the marginal product of each extra unit falls.

Not because later workers are worse — but because each one has less of the fixed factor to work with. The tenth chef in a one-oven kitchen adds almost nothing.

This is why the MC curve slopes upward, why the short-run supply curve slopes upward, and ultimately why the AC curve is U-shaped in the short run: AFC falls steeply at first (dominating), then rising MC drags ATC back up.

Exam trap: diminishing returns is short run (a fixed factor). Diseconomies of scale is long run (all factors variable, the whole plant is bigger). Confusing them is one of the most common ways to lose marks in this topic.

Diminishing returns

Economies and diseconomies of scale

In the long run the firm can change everything — build a bigger factory, adopt different technology. The LRAC curve shows the lowest possible average cost at each output.

Internal economies of scale (falling LRAC as the firm grows) — remember RMFTPM:

• Risk-bearing — a large firm diversifies across products and markets.
• Marketing — bulk-buying discounts (monopsony power over suppliers); the ad campaign costs the same whether you sell 1m or 10m units.
• Financial — big firms borrow more cheaply; they are lower-risk to lenders and can issue bonds and shares.
• Technical — the big one: indivisible capital (a blast furnace, a container ship) can only be used efficiently at high volume; the division of labour; the container ship's capacity rises faster than the steel needed to build it.
• Purchasing / Managerial — specialist managers, accountants and lawyers can be employed and their fixed salaries spread over huge output.

Diseconomies of scale (rising LRAC) — all essentially about coordinating human beings: communication failures and information overload; alienation and falling motivation in a vast organisation; coordination and control costs; slow decision-making through layers of bureaucracy; principal-agent problems multiplying.

Minimum efficient scale (MES) = the lowest output at which LRAC is minimised — the smallest size a firm must reach to be cost-competitive. It matters enormously:

• If MES is large relative to total market demand, only a few firms (or one) can operate efficiently → oligopoly or natural monopoly (rail track, water networks).
• If MES is small, many firms can compete efficiently → competitive markets (hairdressers, plumbers).

External economies of scale come from growth of the whole industry, not the firm: a skilled local labour pool, specialist suppliers clustering nearby, shared infrastructure, university research (Silicon Valley, the City of London). They shift the whole LRAC curve down for every firm.

Internal or external?

Total, average and marginal revenue

Two cases, and they drive everything in market structures:

• Price taker (perfect competition): the firm can sell any quantity at the ruling price, so AR = MR = P and the firm's demand curve is horizontal (perfectly elastic). TR rises in a straight line through the origin.
• Price maker (monopoly, oligopoly, monopolistic competition): to sell more, the firm must cut the price on every unit. So MR < AR, and MR falls twice as steeply as AR. TR rises, peaks where MR = 0, then falls.

Your turn — marginal revenue for a price maker

Normal profit, supernormal profit and shutting down

• Normal profit — the minimum return needed to keep the entrepreneur in this industry rather than the next best one. It is the opportunity cost of enterprise, so economists count it as a cost: it is included in AC. A firm earning normal profit has AR = AC and is "breaking even" in economic terms — it has no incentive to leave, and no incentive for others to enter.
• Supernormal (abnormal/economic) profit — profit above normal: AR > AC. It is the signal that attracts new entrants, and it can only persist in the long run if there are barriers to entry.
• Subnormal profit / loss — AR < AC.
• Accounting profit = revenue − explicit costs only. It ignores implicit opportunity costs, so it is always larger than economic profit. A shop showing an £18,000 accounting profit whose owner turned down a £30,000 job is making an economic loss.

Shut-down decisions. Fixed costs are unavoidable in the short run, so ignore them:

• Short run: keep producing as long as AR ≥ AVC. Any revenue above variable cost makes a contribution towards the fixed costs you must pay anyway. Shut down only if P < AVC.
• Long run: all costs are variable, so the firm must cover them all. Exit if AR < AC.

Your turn — supernormal profit

Your turn — economic profit

Shut down or carry on?

Normal profit

MES and market structure

Internal economy, diseconomy, or external economy?

Tap a card, then tap where it belongs.

Match the term to its definition

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered costs, revenue and profit from the OCR A-level Economics (H460) specification. Press Finish to see your score.