Module 55: Firm Costs

Key Economic Concepts For This Module: In the short run, there are fixed inputs and so there are fixed costs of employing those inputs. The variable inputs must also be employed by paying variable costs. Total cost of production in the short run is the sum of fixed costs and variable costs. TC = VC + FC. Marginal cost of production is the additional cost of producing the next unit of output. MC = ΔTC/ΔQ. Marginal cost may initially decline due to specialization, but eventually diminishing returns to production causes marginal cost to increase with more production. Per-unit, or average costs, are simply dividing total costs by the number of units being produced. ATC = TC/Q; AVC = VC/Q; AFC = FC/Q. The marginal cost curve intersects both ATC and AVC, two U-shaped curves, at their respective minimum points.

Module Presentation Format I. From the Production Function to Cost Curves II. Two Key Concepts: Marginal Cost and Average Cost A. Marginal Cost B. Average Cost C. Minimum Average Total Cost D. Does the Marginal Cost Curve Always Slope Upward?

I. From the Production Function to Cost Curves The previous module covered the production function and diminishing returns. In the short run, there are variable inputs and at least one fixed input. In order to hire these inputs, the firm must pay input prices, and thus incur production costs. 1. Fixed costs(FC) are those costs whose total does not vary with changes in short-run output. These are the payments made to the fixed inputs in the production function.

I. From the Production Function to Cost Curves 1. Fixed costs(FC) are those costs whose total does not vary with changes in short-run output. These are the payments made to the fixed inputs in the production function. 2. Variable costs(VC) are those costs which change with the level of output. These are the payments made to the variable inputs in the production function. 3. Total cost (TC) is the sum of total fixed and total variable costs at each level of output. TC = FC + VC

I. From the Production Function to Cost Curves Why are there costs even with no output?

II. Two Key Concepts: Marginal Cost and Average Cost Marginal cost is the change in total cost DIVIDED by the change in output (q). In this case (and many others) the change in output is 1.

II. Two Key Concepts: Marginal Cost and Average Cost Graphing total costs is not nearly as important in economics as… Marginal costs… Remember--MR=MC is the profit maximizing output.

II. Two Key Concepts: Marginal Cost and Average Cost Marginal cost is the slope of total cost or variable cost. =S MC is the firms SHORT run supply curve

B. Average Cost Average total cost (ATC) is the total cost divided by the level of output (sometimes called average cost, unit cost, or per unit cost ATC = TC/Q We can isolate the variable and fixed costs from the total and compute per-unit variable (average variable) and per unit fixed (average fixed) costs. AVC = VC/Q AFC = FC/Q Because TC = VC + FC, we can rewrite the equation for ATC. ATC = (VC + FC)/Q = AVC + AFC

B. Average Cost • AFC declines as more output is produced. This makes sense since the FC is constant, but we are dividing by more and more output. • The ATC curve has a U-shape. At first it declines, but eventually rises as more output is produced. Why? • ATC has a U-shape because, when more output is produced, two effects are happening:

B. Average Cost • AFC declines as more output is produced. This makes sense since the FC is constant, but we are dividing by more and more output. Fixed cost is spread out over more output. • The ATC curve has a U-shape. At first it declines, but eventually rises as more output is produced. Why? • ATC has a U-shape because, when more output is produced, two effects are happening. One effect, the spreading effect, lowers ATC as more output is produced. The other effect, the diminishing returns effect, causes ATC to rise with more output. The spreading effect. The larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower average fixed cost. The diminishing returns effect. The larger the output, the greater the amount of variable input required to produce additional units, leading to higher average variable cost.

B. Average Cost Note: Fixed cost is $108 and as output increases fixed cost PER UNIT declines. Unfortunately, to produce more, firms have to hire more workers and buy more materials increasing costs. At low levels of output, the spreading effect is very powerful because even small increases in output cause large decreases in AFC, thus pulling down the ATC. As output rises, and diminishing returns becomes a major issue, the upward pull of AVC becomes stronger and begins to pull ATC upward.

C. Minimum Average Total Cost The marginal cost is related to AVC and ATC, but let’s focus on just the relationship with ATC. The ATC will fall as long as the MC<ATC. As soon as the MC rises so that MC>ATC, the ATC will begin to rise. If the MC of the next unit is equal to the current ATC, ATC will not change.

C. Minimum Average Total Cost The marginal cost is related to AVC and ATC, but let’s focus on just the relationship with ATC. The ATC will fall as long as the MC<ATC. As soon as the MC rises so that MC>ATC, the ATC will begin to rise. If the MC of the next unit is equal to the current ATC, ATC will not change.

C. Minimum Average Cost MC will always intersect ATC at the MINIMUM

D. Does the Marginal Cost Curve Always Slope Upward? MC can fall initially due to specializtion of labor in the production function. Before diminishing returns occurs, imagine workers dividing the tasks according to their talents. With this kind of specialization, marginal product rises. But when more units of labor are hired, diminishing returns are experienced and soon MC rises.

D. Does the Marginal Cost Curve Always Slope Upward?

D. Does the Marginal Cost Curve Always Slope Upward?

Key Economic Concepts REVIEW: In the short run, there are fixed inputs and so there are fixed costs of employing those inputs. The variable inputs must also be employed by paying variable costs. Total cost of production in the short run is the sum of fixed costs and variable costs. TC = VC + FC. Marginal cost of production is the additional cost of producing the next unit of output. MC = ΔTC/ΔQ. Marginal cost may initially decline due to specialization, but eventually diminishing returns to production causes marginal cost to increase with more production. Per-unit, or average costs, are simply dividing total costs by the number of units being produced. ATC = TC/Q; AVC = VC/Q; AFC = FC/Q. The marginal cost curve intersects both ATC and AVC, two U-shaped curves, at their respective minimum points.

Practice Question 1. When a firm is producing zero output, total cost equals a. zero. b. variable cost. c. fixed cost. d. average total cost. e. marginal cost.

Practice Question 2. Which of the following statements is true? I. Marginal cost is the change in total cost generated by one additional unit of output. II. Marginal cost is the change in variable cost generated by one additional unit of output. III. The marginal cost curve must cross the minimum of the average total cost curve. a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Question 3. Which of the following is correct? a. AVC is the change in total cost generated by one additional unit of output. b. MC = TC/Q c. The average cost curve crosses at the minimum of the marginal cost curve. d. The AFC curve slopes upward. e. AVC = ATC − AFC

Practice Question 4. The slope of the total cost curve equals a. variable cost. b. average variable cost. c. average total cost. d. average fixed cost. e. marginal cost.

Practice Question 5. The marginal cost curve is a. a market demand curve b. a market supply curve c. the firms short run demand curve d. the firms short run supply curve e. ugly and looks like chicken