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7 | Cost and Industry Structure
Fixed and Variable Costs
Fixed costs are expenditures that do not change regardless of the level of production or factor usage, at least not
in the short term. Whether you produce a lot or a little, the fixed costs are the same.
Variable costs, on the other hand, are incurred in the act of producing—the more you produce, the greater
the variable cost. Labor is treated as a variable cost, since producing a greater quantity of a good or service
typically requires more workers or more work hours. Variable costs would also include raw materials.
The Market Period, Short Run Period, and Long Run Period
Nearly 120 years ago Alfred Marshall defined the periods of production and sale – in the market period, output
could not change (since it had already been produced and was sent to market). During the market period the
price could change, but not output, if there were a sudden change in demand. In the short run, labor could
change, but the scale of the firm (its capital) could not. In the long run, everything could adjust freely, including
the size of the plant (i.e. the amount of physical capital the firm uses). This categorization was later termed
period analysis, and it is still used today, although dynamic economic analysis has moved on to use other tools
and viewpoints. Setting things constant for a period can be convenient, but also misleading, in a fast changing
world.
The Production Function
Q  F (L, K , RM , E,...)
TC
TC
The graphs to the left show clearly how to derive
the Average and Marginal Cost curves from the
Total Cost curve.
As always, the marginal is the slope of the tangent
line to the curve while the average is the slope of the
ray from the origin to the curve.
Q
Q
Note: The Red and Blue rectangles to the
left approximate the marginal cost for each
level of output. Pay particular attention to
the fact that the shape of the cost curve
determines the shape of the marginal cost
curve and that we expect that it falls over
the initial units of output and then begins
to rise steeply as output increases. This
gives marginal cost a type of U-shape