Fixed and variable costs, total, average and marginal cost, the shapes of the short-run cost curves, and the relationship between marginal and average cost.

What this dot point is asking

AQA wants you to define and calculate fixed, variable, total, average and marginal cost, draw the short-run cost curves, and explain the relationship between marginal and average cost. These curves underpin every firm-behaviour model in the course.

Types of cost

• Average total cost is $ATC = \dfrac{TC}{Q}$, and splits into average fixed cost $AFC = \dfrac{FC}{Q}$ and average variable cost $AVC = \dfrac{VC}{Q}$.
• Marginal cost is the change in total cost from producing one more unit, $MC = \dfrac{\Delta TC}{\Delta Q}$.

The short run is defined as the period in which at least one factor (usually capital) is fixed; in the long run all factors are variable, which is where economies of scale apply.

The shapes of the curves

The driver of the U-shape is the law of diminishing returns: in the short run, adding more of the variable factor to a fixed factor eventually raises marginal cost. Because AFC always falls, the gap between ATC and AVC narrows as output grows.

Marginal and average cost

The relationship between marginal and average cost is a recurring exam point:

• When MC is below ATC, ATC is falling.
• When MC is above ATC, ATC is rising.
• MC cuts ATC (and AVC) at its lowest point.

This is the same logic as a test score pulling an average up or down: a marginal value below the average drags the average down, and a marginal value above it pushes the average up. The relationship holds for both average variable cost and average total cost, so the MC curve passes through the minimum of each.

Why the curves matter for decisions

Cost curves are not just descriptive; they drive every firm decision in later topics. The intersection of marginal cost with marginal revenue sets the profit-maximising output. The position of average total cost relative to price (average revenue) determines whether the firm makes supernormal profit, normal profit or a loss. And the relationship between price and average variable cost determines the short-run shut-down decision: a firm continues producing at a loss while price covers AVC, because it is still contributing towards fixed costs, but shuts down if price falls below AVC.

It is also vital to separate the short run from the long run. The U-shape of the short-run curves comes from the law of diminishing returns to a variable factor while capital is fixed. In the long run all factors vary, so the relevant curve is the long-run average cost curve, whose shape comes instead from economies and diseconomies of scale. Confusing the two sources of the U-shape is a common reason answers lose marks.