Y2 2) Fixed and Variable Costs (AFC, TFC, AVC)

Summary

This script discusses short-run costs in business, emphasizing that they occur when at least one production factor is fixed. It differentiates between explicit costs, which require payment, and implicit costs, which represent opportunity costs. The script explains fixed costs, which remain constant regardless of output, and variable costs, which change with output. It also covers average fixed cost, which decreases as output increases, and the average variable cost curve, shaped by the law of diminishing returns. The example of hiring workers to produce units illustrates how increasing returns can reduce average variable costs, but diminishing returns can cause them to rise.

Takeaways

• 🕒 The short-run in business is defined by the presence of at least one fixed factor of production, not by a specific time frame.
• 🏭 In the short-run, businesses typically have two fixed factors of production: land and capital.
• 🔄 The long-run is characterized by all factors of production being variable.
• 💰 Explicit costs are actual payments made by a business, while implicit costs represent the opportunity cost, which is the profit forgone from the next best alternative.
• 💼 Fixed costs are those that do not change with the level of output, such as rent and salaries.
• 📈 Variable costs increase as output increases, including wages, utility bills, raw material costs, and transport costs.
• 📊 Total Fixed Costs (TFC) remain constant and do not vary with output, represented by a horizontal line in cost curves.
• 📉 Average Fixed Cost (AFC) decreases as output increases because it is the TFC divided by an increasing quantity, resulting in a downward-sloping curve.
• 😃 The shapes of TFC and AFC curves are not influenced by the law of diminishing returns, making them straightforward to understand.
• 📈 Average Variable Cost (AVC) is influenced by the law of diminishing returns, initially falling as labor productivity increases and then rising as diminishing returns set in.
• 📘 The shape of the AVC curve resembles a smile, due to the initial increase in labor productivity followed by a decrease as more workers are hired and the law of diminishing returns takes effect.

Q & A

What is the definition of the short-run in business?

The short-run is a period of time in business where there is at least one fixed factor of production. It is not defined by a specific time frame but by the variability of factors of production.

What are the two fixed factors of production in the short-run?

In the short-run, the two fixed factors of production are typically land and capital.

How are costs categorized in economics?

In economics, costs are categorized into explicit costs, which require actual payment, and implicit costs, which are the opportunity costs and do not require physical payment.

What are fixed costs?

Fixed costs are costs that do not vary with output. They must be paid regardless of the level of production, such as rent, salaries, interest on loans, advertising, and business rates.

What are variable costs?

Variable costs are costs that change with the level of output. They increase as more is produced, such as wages, utility bills, raw material costs, and transport costs.

How does the total fixed cost (TFC) curve look graphically?

The total fixed cost curve is a horizontal line, indicating that it remains constant regardless of the level of output.

What is the formula for calculating average fixed cost (AFC)?

The formula for calculating average fixed cost is Total Fixed Cost (TFC) divided by quantity (Q), which results in a downward sloping curve as output increases.

Why does the average variable cost (AVC) curve have a 'smiley face' shape?

The average variable cost curve has a 'smiley face' shape due to the law of diminishing returns. Initially, as more workers are hired, productivity increases, reducing average variable costs. However, as diminishing returns set in, productivity falls, causing average variable costs to rise.

How does the law of diminishing returns affect average variable cost?

The law of diminishing returns causes average variable cost to initially decrease as productivity increases with additional workers, but then to increase as productivity begins to fall once too many workers are hired.

What is the relationship between marginal product and average variable cost?

An increasing marginal product leads to a decrease in average variable cost, while a decreasing marginal product (as a result of diminishing returns) leads to an increase in average variable cost.

What is the next topic to be covered after discussing fixed and variable costs?

The next topic to be covered is marginal cost and average cost, which will be discussed in a subsequent video.

Outlines

00:00

💼 Understanding Short-Run Costs

The paragraph discusses the concept of short-run costs in business, emphasizing that the short-run is defined by the presence of at least one fixed factor of production, typically land and capital. It differentiates between explicit costs, which require payment, and implicit costs, which are the opportunity costs represented by the next best alternative forgone. The paragraph further explains fixed costs, which remain constant regardless of output, and variable costs, which increase with production. Examples of fixed costs include rent, salaries, interest on loans, advertising, and business rates. Variable costs encompass wages, utility bills, raw material costs, and transport costs. The speaker also introduces the idea of mapping cost curves in the short-run, focusing on total fixed costs (TFC) and average fixed costs (AFC), which are not influenced by the law of diminishing returns and hence are straightforward to understand and graph.

05:01

📈 The Shape of Cost Curves

This section delves into the graphical representation of cost curves in the short-run, particularly focusing on total fixed costs (TFC) and average fixed costs (AFC), which are constant and decline as output increases, respectively. The speaker then transitions to discuss the average variable cost (AVC) curve, which is influenced by the law of diminishing returns. An example is used to illustrate how AVC changes with different numbers of workers: initially decreasing due to increasing marginal returns, then increasing as diminishing returns set in. The speaker uses a numerical example with wages as the only variable cost to demonstrate how AVC falls and then rises, reflecting changes in labor productivity and marginal product. The paragraph concludes with a practical demonstration of how these concepts fit into a diagram, showing the relationship between output levels, average variable costs, and the impact of the law of diminishing returns.

Keywords

💡Short-run

The short-run refers to a period of time during which at least one factor of production is fixed. This concept is central to the video's theme as it sets the stage for understanding cost behavior in the short-run versus the long-run. In the script, it's mentioned that typically land and capital are the fixed factors in the short-run, whereas all factors are variable in the long-run.

💡Fixed Costs

Fixed costs are expenses that a business must pay regardless of the level of production. They are a key component in the video's discussion of cost structures. Examples from the script include rent, salaries, interest on loans, and business rates. These costs do not change with output, which is why they are depicted as a horizontal line in the cost curves.

💡Variable Costs

Variable costs are expenses that vary with the level of output. They are directly tied to the production level, as more is produced, more variable costs are incurred. The script gives examples such as wages, utility bills, raw material costs, and transport costs. These costs are integral to understanding how average variable costs change due to the law of diminishing returns.

💡Explicit Costs

Explicit costs are actual monetary payments that a business must make. They are distinguished from implicit costs in the video. Explicit costs include things like rent and wages, which are directly paid out by the business. The script emphasizes that these are the costs that are physically paid.

💡Implicit Costs

Implicit costs represent the opportunity cost of using resources, which does not involve an actual monetary payment. The video explains that for a business, implicit costs are the profits forgone by not pursuing the next best alternative. This concept is crucial for understanding total economic costs.

💡Total Fixed Costs (TFC)

Total Fixed Costs are the sum of all fixed costs a business incurs. In the video, it's explained that TFC does not change with the level of output, which is why it is represented as a flat line in the cost curves. The script provides an equation to calculate TFC, which is simply the fixed costs that do not vary with output.

💡Average Fixed Cost (AFC)

Average Fixed Cost is calculated by dividing Total Fixed Costs by the quantity of output. The video explains that as output increases, AFC decreases because the fixed costs are spread over more units. The script uses the equation AFC = TFC / Q to illustrate how AFC declines as output (Q) increases.

💡Law of Diminishing Returns

The law of diminishing returns is a principle that as more units of a variable input are used, the additional output (marginal return) will eventually decrease. This law is central to the video's explanation of why average variable costs initially decrease and then increase, forming a 'U' shape curve. The script provides a numerical example to demonstrate this concept.

💡Average Variable Cost (AVC)

Average Variable Cost is the cost per unit of output for variable costs. It is influenced by the law of diminishing returns, as explained in the video. AVC decreases initially as more workers are hired due to increasing marginal returns but starts to increase once diminishing returns set in. The script uses a numerical example with workers and wages to illustrate this.

💡Marginal Product

Marginal product refers to the additional output produced by using one more unit of a variable input. The video uses the concept of marginal product to explain how increasing it can reduce average variable costs. However, as the law of diminishing returns takes effect, the marginal product decreases, which in turn increases average variable costs.

💡Total Variable Cost (TVC)

Total Variable Cost is the sum of all variable costs incurred by a business. The video script mentions that TVC changes with the level of output and is an essential component in calculating average variable cost. TVC is the basis for understanding how costs behave as production levels change.

Highlights

The short-run is defined by the presence of at least one fixed factor of production.

In the short-run, land and capital are typically fixed factors of production.

Costs are divided into explicit costs (requiring payment) and implicit costs (opportunity costs).

Fixed costs are independent of the level of output produced.

Variable costs increase as more output is produced.

Examples of fixed costs include rent, salaries, interest on loans, advertising, and business rates.

Variable costs include wages, utility bills, raw material costs, and transport costs.

Total fixed costs (TFC) remain constant regardless of output.

Average fixed cost (AFC) decreases as output increases due to dividing a constant by an increasing number.

The shapes of TFC and AFC curves are not influenced by the law of diminishing returns.

Average variable cost (AVC) is influenced by the law of diminishing returns, resulting in a U-shaped curve.

An increase in labor productivity can reduce average variable costs.

Diminishing returns set in when additional workers lead to a decrease in marginal product and an increase in AVC.

The AVC curve's shape is explained by the law of diminishing returns and changes in labor productivity.

The video will cover marginal cost and average cost in upcoming episodes.

Transcripts

hi everybody short-run costs we'll

remember what the short-run is for a

business it is a period of time when

there is at least one fixed factor of

production we don't define it in terms

of six months or one year we don't

define it in terms of actual time we

define it in terms of the variability of

our factors of production so when there

is at least one fixed factor production

and business is in the short-run usually

there are two fixed factors of

production in the short-run land and

capital whereas in the long-run all

factors of production are variable

that's a crucial start but also costs

are quite unique in economics there are

two different groups of costs we have

our explicit costs costs that require

actual payment and we have our implicit

costs implicit costs for a business is

just their opportunity cost and that's

always the profit they could have made

doing their next best alternative that

is a cost

it doesn't require physical payment

therefore its implicit but it is a cost

and then we have our two explicit costs

of fixed costs and our variable costs

fixed costs are costs that do not vary

with output so even if nothing is being

produced a business has to pay fixed

costs where is variable costs are costs

that do vary with output you pay more of

these as you produce more so let's take

some examples of fixed cost cost you

have to pay regardless of how much

output you're producing things like rent

salaries salaries are contractual right

so you have to pay those regardless of

how much you're producing usually a

yearly contract there so salaries are

fixed interest on loans advertising

business rates this is taxes and having

a physical premises as a business here

business rates these are all cost you

have to pay regardless of how much apple

you're producing where it's variable

costs if you look at these you have to

pay more of these the more you're

producing wages are more flexible than

salaries are wages can change more

quickly so wages are a variable cost

utility bills so your gas electricity

bills your water bills internet bills

they're all a variable your raw material

cost your transport costs all will

increase the more that you produce so

these are variable whereas these are

some good examples of fixed costs what

we want to do now is to map what our

cost codes look like in the short-run

and in this video we're going to look at

a fixed cost average fixed cost an

average variable cost total fix costs an

average fixed cost are very very easy to

draw because their shapes have got

nothing to do with the law of

diminishing returns it's the only two

cost curves in the short-run that have

got nothing to do with the law of

diminishing returns so they are very

easy to draw let's start by looking at

total fixed costs Weaver said that fixed

costs are costs that do not vary with

output so total fixed costs is just

going to be constant it's gonna be on a

constant figure over a given range of

output so total fixed cost is just gonna

look like that really simple I've put

some equations at the top of how you can

work out total fixed cost average fixed

cost well let me take this equation to

use and calculate average fixed cost TFC

over q when we know that TFC is a fixed

number it's a constant number and if Q

is rising output is increasing

increasing you're dividing a constant

number by an ever-increasing number and

that means your average fixed cost is

gonna fall for for the more that we

produce or average fixed cost is gonna

look something like that downward

sloping looking like that using this

equation that makes a lot of sense so

these two cares are very simple to

remember make sure we learn the

equations as well they are shaped not

because of the law of diminishing

returns at all so therefore very simple

to get your head around the average

variable cost curve though is shade due

to the law of diminishing returns we're

going to look at that now the average

variable cost curve looks like this

looks like a nice smiley face to

calculate it we get a total variable

cost divided by quantity or we can do

average cost minus average fixed cost

but why does it look like this smiley

face well due to the law of diminishing

marginal returns let's understand how by

using a very simple numerical example

let's assume that there is a business

and for this business operating in the

short-run wages are the only variable

cost and we'll also assume that workers

are paid a daily wage rate of a hundred

pounds let's say one worker is hired

that means total variable cost is a

hundred pounds and let's say that worker

produces ten units well average variable

cost is therefore a hundred divided by

ten that's going to be ten pounds let's

now say to work is a hide total variable

cost is 200 pounds together they produce

30 units 200 divided by 30

is 6 pounds 67 to 2 DP let's now say 3

workers are hired total variable cost is

gonna be 300 pounds they together

produce 70 units and therefore ABC is

300 divided by 70 that's going to give

us 4 pounds and 28 to 2 DB so what we

can see here is up to 3 workers can we

see that there are increasing returns to

labor labor productivity is rising

marginal product is rising and that is

reducing average variable cost marginal

product is 10 here then 20 and then 40

increasing marginal product increasing

labor productivity will reduce average

variable cost but look the law of

diminishing returns diminishing returns

kicks in when we hire this fourth worker

so four workers are hired total variable

cost is now 400 pounds and these workers

together produce 80 units that means

that average variable cost is 400 about

880 that's 5 pounds let's keep going 5

workers are hired TVCs 500 and they

produce 85 units 500 divided by 85 is 5

pounds and 88 to 2 decimal places

let's go all the way down to 10 workers

are hired that means total variable cost

of a thousand pounds they produce 100

units let's say that's average variable

cost of 10 pounds so we can see that

when we hire this fourth worker

diminishing returns kick in marginal

product is falling from 40 there to 10

to 5 right it's decreasing when labor

productivity is falling and marginal

product is falling average variable

costs will be rising okay so we can see

that average variable cost will fall but

when the law of diminishing returns

kicks in it will start to rise and that

explains the shape here how we can put

these numbers to our diagram you don't

need to do this or make things

unnecessarily messy but let's do it

together so for the first 10 units for

the first 10 years let's say we're over

here so that's 10 units there we have a

VC of 10 pounds but then we have 30

units coming next so let's say 30 units

gives us an average variable cost of

6.67 so that fits nicely there and then

to get the 70 units we hit on minimum so

70 is there and we get to 4 pounds

28 so we can see higher labor

productivity we see a higher marginal

product and a reduction in average

variable cost then diminishing returns

kicks in so to get to 80

it's here to get to 80 let's say it's

over here somewhere we get to an average

variable cost of five to get to 85 which

is only just over there let's say 85 we

get to five pounds 88 etc and then when

we get to 100 when we get to 100 which

is over here we get back to our average

variable cost of ten so the numbers very

much fit the diagram lovely so that

explains the shape of the AVC curve very

much due to the law of diminishing

returns whereas our fixed cost curves

TFC and AFC had nothing to do with the

law of diminishing returns in fact they

are the only two curves that we learn

only two short-run Costco's they've got

nothing to do a law of diminishing

returns all the others are because of

this law so three curves there we are

not going to touch total variable cost I

do that in a video later in this

playlist check that out if you want but

we now need to continue look at marginal

cost and average cost that's coming next

make sure you stay tuned for that very

important video I'll see you then

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