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Total cost can be divided into fixed cost and variable cost. Fixed costs are those costs, which in total do not vary with changes in output (e.g. rental payments). On the other hand, variable costs are those costs, which changes with the level of output (e.g. charges on fuel and electricity, payments of raw materials). Thus, the total cost function can be represented as TC = TV C + TEC. Average Cost (AC) is equal to Average Fixed Cost (AFC) plus Average Variable Cost (AVC) [AC = AFC + AVC].
Marginal cost is the additional or extra cost that the firm is required to incur for the production of one additional unit of output. The shape of the Average Fixed Cost (AFC) is rectangular hyperbola because if output increases, the average fixed cost drops down.
A firm's cost curves and product curves are like mirror images. When marginal product is minimum (maximum), marginal cost is maximum (minimum). When law of diminishing returns operates, the marginal product falls and the marginal cost rises. Over the range of rising average product, average variable cost is falling. The short run average cost curves are U-shaped. Marginal cost intercepts both the average variable cost and average cost curves at their respective minimum points.
In the long run, all factors of production are variable. The long run cost curve is also known as the planning curve, since it guides the entrepreneur in his/her decision to plan for the future expansion of output. The long run total cost curve is derived from the short run total cost curves.
The long run average cost is the locus of the tangency points of the short run average cost curves. And therefore, long run average cost curve is known as envelope curve. The long run marginal cost curve is derived from the short run marginal cost (SMC) curves but does not 'envelope' them. The LMC curve is formed from points of intersection of the SMC curves with the vertical line drawn (to the X-axis) from the points of tangency of the corresponding SAC curves and the LAC curve. The LMC must be equal to the SMC for the output at which the corresponding SAC is tangent to the LAC curve. By joining these points of intersection we get the LMC curve of the firm.
Economies of scale arise from an increase in the number of plants of a firm, irrespective of whether the firm continues to produce the same product in the new plants or diversifies. Economies of scale are distinguished into real economies and pecuniary economies of scale. Real economies are those associated with a reduction in the physical quantity of inputs, raw materials, various types labor and various types of capital (fixed or circulating capital). Pecuniary economies are economies realized from paying lower prices for the factors used in the production and distribution of the product, due to bulk buying by the firm as its size increases.