A Matter of Costs

The rate at which variable cost changes in the short run is related to the nature of the fixed cost.

On hot summer days with high electricity demand, the average cost of power generation shoots up. What might cause this sudden increase in cost?

The following reasons might be at play:

• The optimal capacity of the main power generators might have been exceeded. More fuel is needed to generate additional units of power.
• The public utility company might have a long-term contract with the fuel supplier that limits the daily usage quota. Higher spot market price would apply when this quota is exceeded.
• Less energy-efficient backup power generators might have to be brought on line when the capacity of the main power generators has been exceeded.
• Emission credits might have to be purchased to run the less energy-efficient and more polluting backup power generators.

The exact reasons might be less important than the insight that the cost drivers are related to the variable cost¹ of fuel and emission credits and not the fixed cost² of the power generators. With some cost being fixed in the short run, average fixed cost will drop with higher output as the fixed cost is spread over more output units. So the rise in average total cost could be explained entirely by the increase in total variable cost. The rate of increase in total variable cost is reflected in the marginal cost³. When total variable cost goes up at an increasing rate, average variable cost goes up with it. But marginal cost which applies only to the marginal unit is even higher than average variable cost which spreads out the total variable cost over the total output (see Marginal Cost and Average Total Cost - youtube).

The example of power generation is a classic case of diminishing returns due to the nature of the capacity constraints in the short run (see Law of Diminishing Returns). Here, it seems like the fixed cost is the cause of diminishing returns. But under different technology, the fixed cost might lead to very small increase in the variable cost for higher output.

In the case of software, the high fixed cost of developing code is justified by the low reproduction cost of the finished product (see The Snowball Effect). The rate of increase in the variable cost stays almost constant and low over output. As a result, the average total cost which is dominated by the declining average fixed cost falls as the high fixed cost is spread over larger output. This then is the case of increasing returns. Under increasing returns, marginal variable cost is below the average total cost.

Whether marginal cost is above or below average total cost has important implications on the pursuit of profit vs efficiency. Economic efficiency requires that price be set equal to marginal cost. When marginal cost is above average total cost, this requirement could still result in positive profit. But when marginal cost is below average total cost, setting price equal to marginal cost will result in negative profit (see Profit maximization under natural monopoly).