Perfect competition II: Cost variation

Firms’ cost structures will change over time, even when the quantity produced is kept constant. The price of an essential input for the production or the cost of rent may inevitably change. New costs will modify a firm’s equilibrium quantity and price. Once the differences between fixed and variable, and average and marginal costs are understood, it’s interesting to use comparative statics in order to see how new, higher costs may vary the firm’s cost structure, as well as the market structure as a whole. This analysis must be done in the long term, since long run cost analysis considers changes in both variable and fixed costs, and allows the entry and exit of firms to and from the market.

Fixed costs

If fixed costs increase but the initial market equilibrium is still maintained on the point in which average costs used to be at its lowest (A), the firm will incur in losses. Increases in fixed costs automatically imply an increase in average total cost. If a firm has an increase in its costs, it can easily result in losses that will cause it to exit the market, and thus motivate a contraction on supply. This contraction will cause an increase in price that eventually will result in a decrease in the demand for the product. Since there is a shift in demand to the left, less total quantity will be sold. However, because some firms exit the market, quantity produced by remaining firms will increase. It must be noted that the lowest possible supply level (X) remains unchanged because variable costs remain unchanged.

Variable costs

When variable costs increase, they cause an upward shift in the marginal and average cost curves.  The market production costs will increase causing a contraction in supply, and thus firms exiting the market. Remaining firms will keep producing the same quantity of goods. Note that here the lowest possible supply level (X) changes because variable costs increase.