Cost curve

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free
market economy, productively ecient rms use these
curves to nd the optimal point of production (minimizing cost), and prot maximizing rms can use them to
decide output quantities to achieve those aims. There are
various types of cost curves, all related to each other, including total and average cost curves, and marginal (for
each additional unit) cost curves, which are equal to the
dierential of the total cost curves. Some are applicable
to the short run, others to the long run.

in such a way that the factors of production is at the lowest

point. In the short run, when at least one factor of production is xed, this occurs at the output level where it has
enjoyed all possible average cost gains from increasing
production. This is at the minimum point in the diagram
on the right.
Short-run total cost is given by
ST C = PK .K + PL .L ,
where PK is the unit price of using physical capital per
unit time, PL is the unit price of labor per unit time (the
wage rate), K is the quantity of physical capital used, and
L is the quantity of labor used. From this we obtain shortrun average cost, denoted either SATC or SAC, as STC /
Q:

Short-run average variable cost

curve (SRAVC)

SRATC or SRAC = PKK/Q + PLL/Q = PK /

APK + PL / APL,
where APK = Q/K is the average product of capital and
APL = Q/L is the average product of labor.[1]:191
Short run average cost equals average xed costs plus average variable costs. Average xed cost continuously falls
as production increases in the short run, because K is xed
in the short run. The shape of the average variable cost
curve is directly determined by increasing and then diminishing marginal returns to the variable input (conventionally labor).[2]:210
A U shaped short run Average Cost(AC) curve. AVC is the Average Variable Cost, AFC the Average Fixed Cost, MC the marginal
cost crossing the minimum of the Average Cost curve.

3 Long-run average cost curve

(LRAC)

Average variable cost (which is a short-run concept) is

the variable cost (typically labor cost) per unit of output:
SRAVC = wL / Q where w is the wage rate, L is the
quantity of labor used, and Q is the quantity of output
produced. The SRAVC curve plots the short-run average
variable cost against the level of output and is typically
drawn as U-shaped.

Price
LRAC

Short-run average total cost

curve (SRATC or SRAC)

The average total cost curve is constructed to capture the

Q1
Q2
relation between cost per unit of output and the level of
output, ceteris paribus. A perfectly competitive and productively ecient rm organizes its factors of production Typical long run average cost curve
1

Quantity

2
The long-run average cost curve depicts the cost per unit
of output in the long runthat is, when all productive
inputs usage levels can be varied. All points on the line
represent least-cost factor combinations; points above the
line are attainable but unwise, while points below are
unattainable given present factors of production. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. Given
that LRAC is an average quantity, one must not confuse it with the long-run marginal cost curve, which is
the cost of one more unit.[3]:232 The LRAC curve is created as an envelope of an innite number of short-run
average total cost curves, each based on a particular xed
level of capital usage.[3]:235 The typical LRAC curve is Ushaped, reecting increasing returns of scale where negatively sloped, constant returns to scale where horizontal
and decreasing returns (due to increases in factor prices)
where positively sloped.[3]:234 Contrary to the assertion of
Canadian economist Jacob Viner,[4] the envelope is not
created by the minimum point of each short-run average
cost curve.[3]:235 This mistake is recognized as Viners Error.
In a long-run perfectly competitive environment, the
equilibrium level of output corresponds to the minimum
ecient scale, marked as Q2 in the diagram. This is due
to the zero-prot requirement of a perfectly competitive
equilibrium. This result implies production is at a level
corresponding to the lowest possible average cost,[3]:259
does not imply that production levels other than that at
the minimum point are not ecient. All points along the
LRAC are productively ecient, by denition, but not all
are equilibrium points in a long-run perfectly competitive
environment.

LONG-RUN MARGINAL COST CURVE (LRMC)

Price
MC

MR

Quantity

Typical marginal cost curve

at small quantities of output; then as production increases,

marginal cost declines, reaches a minimum value, then
rises. The marginal cost is shown in relation to marginal
revenue (MR), the incremental amount of sales revenue
that an additional unit of the product or service will bring
to the rm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal
returns (and the law of diminishing marginal returns).
Marginal cost equals w/MPL.[1]:191 For most production
processes the marginal product of labor initially rises,
reaches a maximum value and then continuously falls as
production increases. Thus marginal cost initially falls,
reaches a minimum value and then increases.[2]:209 The
marginal cost curve intersects both the average variable
cost curve and (short-run) average total cost curve at their
minimum points. When the marginal cost curve is above
an average cost curve the average curve is rising. When
the marginal costs curve is below an average curve the
average curve is falling. This relation holds regardless of
whether the marginal curve is rising or falling.[3]:226

In some industries, the bottom of the LRAC curve is large

in comparison to market size (that is to say, for all intents and purposes, it is always declining and economies
of scale exist indenitely). This means that the largest
5 Long-run marginal cost curve
rm tends to have a cost advantage, and the industry tends
naturally to become a monopoly, and hence is called a
(LRMC)
natural monopoly. Natural monopolies tend to exist in
industries with high capital costs in relation to variable The long-run marginal cost curve shows for each unit of
costs, such as water supply and electricity supply.[3]:312
output the added total cost incurred in the long run, that
is, the conceptual period when all factors of production
are variable so as minimize long-run average total cost.
otherwise, LRMC is the minimum increase in to4 Short-run marginal cost curve Stated
tal cost associated with an increase of one unit of output
when all inputs are variable.[5]
(SRMC)
A short-run marginal cost curve graphically represents
the relation between marginal (i.e., incremental) cost incurred by a rm in the short-run production of a good or
service and the quantity of output produced. This curve is
constructed to capture the relation between marginal cost
and the level of output, holding other variables, like technology and resource prices, constant. The marginal cost
curve is usually U-shaped. Marginal cost is relatively high

The long-run marginal cost curve is shaped by returns to

scale, a long-run concept, rather than the law of diminishing marginal returns, which is a short-run concept. The
long-run marginal cost curve tends to be atter than its
short-run counterpart due to increased input exibility as
to cost minimization. The long-run marginal cost curve
intersects the long-run average cost curve at the minimum
point of the latter.[1]:208 When long-run marginal costs
are below long-run average costs, long-run average costs

3
are falling (as to additional units of output).[1]:207 When
long-run marginal costs are above long run average costs,
average costs are rising. Long-run marginal cost equals
short run marginal-cost at the least-long-run-average-cost
level of production. LRMC is the slope of the LR totalcost function.

Graphing cost curves together

Price

MC

ATC

economies nor diseconomies of scale if it has constant

returns to scale. In this case, with perfect competition in
the output market the long-run market equilibrium will
involve all rms operating at the minimum point of their
long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).
If, however, the rm is not a perfect competitor in the input markets, then the above conclusions are modied. For
example, if there are increasing returns to scale in some
range of output levels, but the rm is so big in one or
more input markets that increasing its purchases of an input drives up the inputs per-unit cost, then the rm could
have diseconomies of scale in that range of output levels.
Conversely, if the rm is able to get bulk discounts of
an input, then it could have economies of scale in some
range of output levels even if it has decreasing returns in
production in that output range.

MR

8 Relationship between dierent

curves
Quantity

Cost curves in perfect competition compared to marginal revenue

Cost curves can be combined to provide information

about rms. In this diagram for example, rms are assumed to be in a perfectly competitive market. In a perfectly competitive market the price that rms are faced
with would be the price at which the marginal cost curve
cuts the average cost curve.

Total Cost = Fixed Costs (FC) + Variable Costs

(VC)
Marginal Cost (MC) = dC/dQ; MC equals the slope
of the total cost function and of the variable cost
function
Average Total Cost (ATC) = Total Cost/Q
Average Fixed Cost (AFC) = FC/Q
Average Variable Cost (AVC) = VC/Q.

Cost curves and production functions

Assuming that factor prices are constant, the production function determines all cost functions.[2] The variable cost curve is the inverted short-run production function or total product curve and its behavior and properties are determined by the production function.[1]:209 [nb 1]
Because the production function determines the variable cost function it necessarily determines the shape and
properties of marginal cost curve and the average cost
curves.[2]

ATC = AFC + AVC

The MC curve is related to the shape of the ATC
and AVC curves:[9]:212
At a level of Q at which the MC curve is above
the average total cost or average variable cost
curve, the latter curve is rising.[9]:212
If MC is below average total cost or average
variable cost, then the latter curve is falling.
If MC equals average total cost, then average
total cost is at its minimum value.

If MC equals average variable cost, then average variable cost is at its minimum value.
If the rm is a perfect competitor in all input markets, and
thus the per-unit prices of all its inputs are unaected by
how much of the inputs the rm purchases, then it can
be shown[6][7][8] that at a particular level of output, the 9 Relationship between short run
rm has economies of scale (i.e., is operating in a downand long run cost curves
ward sloping region of the long-run average cost curve)
if and only if it has increasing returns to scale. Likewise,
it has diseconomies of scale (is operating in an upward Basic: For each quantity of output there is one cost minisloping region of the long-run average cost curve) if and mizing level of capital and a unique short run average cost
only if it has decreasing returns to scale, and has neither curve associated with producing the given quantity.[10]

10 U-SHAPED CURVES
Each STC curve can be tangent to the LRTC curve
at only one point. The STC curve cannot cross (intersect) the LRTC curve.[2]:230[9]:228229 The STC
curve can lie wholly above the LRTC curve with
no tangency point.[11]:256
One STC curve is tangent to LRTC at the long-run
cost minimizing level of production. At the point of
tangency LRTC = STC. At all other levels of production STC will exceed LRTC.[12]:292299
Average cost functions are the total cost function divided by the level of output. Therefore, the SATC
curveis also tangent to the LRATC curve at the costminimizing level of output. At the point of tangency LRATC = SATC. At all other levels of production SATC > LRATC[12]:292299 To the left of the
point of tangency the rm is using too much capital and xed costs are too high. To the right of the
point of tangency the rm is using too little capital
and diminishing returns to labor are causing costs to
increase.[13]
The slope of the total cost curves equals marginal
cost. Therefore, when STC is tangent to LTC, SMC
= LRMC.
At the long run cost minimizing level of output
LRTC = STC; LRATC = SATC and LRMC =
SMC,.[12]:292299
The long run cost minimizing level of output may be
dierent from minimum SATC,.[9]:229[14]:186

If production process is exhibiting constant returns

to scale then minimum SRAC equals minimum long
run average cost. The LRAC and SRAC intersect
at their common minimum values. Thus under constant returns to scale SRMC = LRMC = LRAC =
SRAC .
If the production process is experiencing decreasing or increasing, minimum short run average cost
does not equal minimum long run average cost. If
increasing returns to scale exist long run minimum
will occur at a lower level of output than SRAC. This
is because there are economies of scale that have
not been exploited so in the long run a rm could
always produce a quantity at a price lower than minimum short run average cost simply by using a larger
plant.[15]
With decreasing returns, minimum SRAC occurs at
a lower production level than minimum LRAC because a rm could reduce average costs by simply
decreasing the size or its operations.
The minimum of a SRAC occurs when the slope is
zero.[16] Thus the points of tangency between the
U-shaped LRAC curve and the minimum of the
SRAC curve would coincide only with that portion
of the LRAC curve exhibiting constant economies
of scale. For increasing returns to scale the point of
tangency between the LRAC and the SRAc would
have to occur at a level of output below level associated with the minimum of the SRAC curve.

With xed unit costs of inputs, if the production

These statements assume that the rm is using the optimal
function has constant returns to scale, then at the
level of capital for the quantity produced. If not, then
minimal level of the SATC curve we have SATC =
the SRAC curve would lie wholly above the LRAC and
LRATC = SMC = LRMC.[12]:292299
would not be tangent at any point.
With xed unit costs of inputs, if the production
function has increasing returns to scale, the minimum of the SATC curve is to the right of the 10 U-shaped curves
point of tangency between the LRAC and the SATC
curves.[12]:292299 Where LRTC = STC, LRATC =
Both the SRAC and LRAC curves are typically expressed
SATC and LRMC = SMC.
as U-shaped.[9]:211; 226 [14]:182;187188 However, the shapes
With xed unit costs of inputs and decreasing re- of the curves are not due to the same factors. For the
slope is largely due
turns the minimum of the SATC curve is to the short run curve the initial downward
[2]:227
to
declining
average
xed
costs.
Increasing returns
left of the point of tangency between LRAC and
[12]:292299
to
the
variable
input
at
low
levels
of
production
also play
SATC.
Where LRTC = STC, LRATC =
[17]
while
the
upward
slope
is
due
to
diminishing
a
role,
SATC and LRMC = SMC.
marginal returns to the variable input.[2]:227 With the long
With xed unit input costs, a rm that is experienc- run curve the shape by denition reects economies and
[14]:186
At low levels of production
ing increasing (decreasing) returns to scale and is diseconomies of scale.
producing at its minimum SAC can always reduce long run production functions generally exhibit increasing
average cost in the long run by expanding (reduc- returns to scale, which, for rms that are perfect competitors in input markets, means that the long run average cost
ing) the use of the xed input.[12]:29299 [14]:186
is falling;[2]:227 the upward slope of the long run average
LRATC will always equal to or be less than cost function at higher levels of output is due to decreasSATC.[1]:211
ing returns to scale at those output levels.[2]:227

11

Cost curves in reality

The U-shaped cost curves have no basis in fact. In a survey by Wilford J. Eiteman and Glenn E. Guthrie in 1952
managers of 334 companies were shown a number of different cost curves, and asked to specify which one best
represented the companys cost curve. 95% of managers
responding to the survey reported cost curves with constant or falling costs.[18]
Alan Blinder, former vice president of the American Economics Association, conducted the same type of survey in 1998, which involved 200 US rms in a sample that should be representative of the US economy at
large. He found that about 40% of rms reported falling
variable or marginal cost, and 48.4% reported constant
marginal/variable cost.[19]

12

See also

Cost
Economic cost
General equilibrium
Joel Dean (economist)
Partial equilibrium
Point of total assumption

13

Notes

[1] The slope of the short-run production function equals the

marginal product of the variable input, conventionally labor. The slope of the variable cost function is marginal
costs. The relationship between MC and the marginal
product of labor MPL is MC = w/MPL. Because the wage
rate w is assumed to be constant the shape of the variable
cost curve is completely dependent on the marginal product of labor. The short-run total cost curve is simply the
variable cost curve plus xed costs.

14

References

[1] Perlo, J. Microeconomics, 5th ed. Pearson, 2009.

[2] Perlo, J., 2008, Microeconomics: Theory & Applications
with Calculus, Pearson. ISBN 978-0-321-27794-7
[3] Lipsey, Richard G. (1975). An introduction to positive economics (fourth ed.). Weidenfeld & Nicolson. pp. 578.
ISBN 0-297-76899-9.
[4] Viner, Jacob (1931).
Costs Curves and Supply
Curves. Zeitschrift fr Nationalkonomie 3 (1): 2346.
doi:10.1007/BF01316299. Reprinted in Emmett, R. B.,
ed. (2002). The Chicago Tradition in Economics, 1892
1945 6. Routledge. pp. 192215.

[5] Sexton, Robert L., Philip E. Graves, and Dwight R. Lee,

1993. The Short- and Long-Run Marginal Cost Curve:
A Pedagogical Note, Journal of Economic Education,
24(1), p. 34. [Pp. 34-37 (press +)].
[6] Gelles, Gregory M., and Mitchell, Douglas W., Returns
to scale and economies of scale: Further observations,
Journal of Economic Education 27, Summer 1996, 259261.
[7] Frisch, R., Theory of Production, Drodrecht: D. Reidel,
1965.
[8] Ferguson, C. E., The Neoclassical Theory of Production
and Distribution, London: Cambridge Univ. Press, 1969.
[9] Pindyck, R., and Rubinfeld, D., Microeconomics, 5th ed.,
Prentice-Hall, 2001.
[10] Nicholson: Microeconomic Theory 9th ed. Page 238
Thomson 2005
[11] Kreps, D., A Course in Microeconomic Theory, Princeton
Univ. Press, 1990.
[12] Binger, B., and Homan, E., Microeconomics with Calculus, 2nd ed., Addison-Wesley, 1998.
[13] Frank, R., Microeconomics and Behavior 7th ed. (McGraw-Hill) ISBN 978-0-07-126349-8 at 321.
[14] Melvin & Boyes, Microeconomics, 5th ed., Houghton Mifin, 2002
[15] Perlo, J. Microeconomics Theory & Application with
Calculus Pearson (2008) p. 231.
[16] Nicholson: Microeconomic Theory 9th ed. Page Thomson 2005
[17] Boyes, W., The New Managerial Economics, Houghton
Miin, 2004.
[18] Wilford J. Eiteman and Glenn E. Guthrie, The Shape
of the Average Cost Curve, American Economic Review,
42.5: 832838
[19] Alan Stuart Blinder, Asking about Prices: A New Approach to Understanding Price Stickiness, Russell Sage
Foundation, New York, 1998

15

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