Costs in the Short Run

Fixed Costs & Average Fixed Costs The labor-output relationship involves different types of costs. Fixed costs (FC): are costs that do not vary with changes in output Example; Rental payments, interest on a firm’s debt, depreciation, and insurance premiums. Average fixed costs (AFC): is the fixed cost per unit of output AFC = FC ÷ Quantity

Variable Costs Variable costs (VC): are costs that change with the level of output Example; Materials, labor, fuel

Average Variable & Marginal Cost Average variable cost (AVC): is the variable cost per unit of output Marginal variable cost (MVC): ∆VC ÷ ∆Quantity

Total Cost Total Cost: is the sum of all fixed and variable costs at each quantity of output TC = FC + VC

Average Cost & Marginal Cost Average cost (AC): is the sum of average fixed cost (AFC) and average variable cost (AVC) at each quantity of output AC = AFC + AVC Alternatively, AC= TC ÷ Quantity Marginal cost (MC): is the extra cost for an additional unit of output MC= ∆TC ÷∆Quantity

Marginal Cost Marginal decisions are very important in determining profit levels for firms Marginal cost is a reflection of marginal product and diminishing returns The marginal cost is related to AVC and ATC As soon as the marginal cost rises above the average the averages will begin to rise

Shape of the AVC and MC Curves Question: Why are the AVC and MC curves U-shaped? Key Idea: Each additional worker adds the same amount to total cost but a different amount to total output AVC: 1) Increasing APL implies decreasing AVC 2) Diminishing APL of the variable factor implies rising AVC 3) AVC is at its minimum when APL reaches its maximum MC: 1) Increase MPL implies decreasing MC 2) Diminishing MPL of the variable factor implies rising MC 3) MC is at its minimum when MPL reaches its maximum

Per Unit Short-Run Production Costs There are several key relations of MC to AVC and ATC When MC < current ATC then ATC will fall When MC > current ATC then ATC will rise MC intersects ATC and AVC at minimum points

Example; Short-Run Costs for T-Shirts Total Product 80 200 250 270 280 Fixed Costs 825 Variable Costs 140 300 425 535 640 Total Costs 825 965 1125 1250 1360 1465 ∆Total Costs 140 160 125 110 105 Marginal Cost 1.75 1.33 2.50 5.50 10.50 AFC 10.31 4.13 3.30 3.06 2.95 AVC 1.75 1.50 1.70 1.98 2.29 AC 12.06 5.63 5.00 5.04 5.24

Shifts of the Costs Curves Changes in either resource prices or technology will cause costs to change and therefore the cost curves to shift. Changes in fixed cost shifts the AFC and the ATC curves, but AVC and MC would remain the same since variable costs are independent of fixed costs. Changes in the price of labor or some other variable input shifts AVC, ATC, and MC.

Profit Maximizing Equilibrium Recall, that a firms main objective is to maximize profits A profit maximizing firm will produce at a point where it will makes the largest profit. This occurs where total revenue exceeds total cost by the largest amount

Alternatively, marginal revenue (MR) and marginal costs (MC) can be used to determine the profit maximizing equilibrium The firm examines the costs and revenue of producing an additional unit of output If MR < MC then the firm is making a loss on the additional unit and should reduce its output If MR > MC then the firm is making a profit on the additional unit and should increase its output If MR = MC then the firm is in equilibrium and maximizing profit At any other point more profit can be made by expanding or contracting output towards this point