Cost curve
A cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.
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Average Total Cost curve (ATC)
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ATC curve
The average total cost curve is constructed to capture the relation between average total cost and the level of output, ceteris paribus. A productively efficient firm organises its factors of production in such a way that the average cost of production is at lowest point. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for increasing returns exist. This is at the minimum point in the diagram on the right.
Long-Run Average Cost curve (LRAC)
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LRAC curve
The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost curves. The envelope is based on the point of each short-run ATC curve that provides the lowest possible average cost for each quantity of output. The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this, case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm is not large enough to experience diseconomies of scale. This occurs at output level Q2 in the diagram.
Marginal Cost curve (MC)
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MC curve
A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product 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 U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns).
Combining cost curves
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Perfect competition
We can combine cost curves to provide information about firms. In this diagram for example, we are assuming that the firm is in a perfectly competitive market. The MC curve will cross the lowest point of the ATC curve, which is also where MC crosses MR. The firm will produce it's good at this point to achieve the maximum profit.