# Module 55 Firm Costs. What you will learn in this Module:

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1 What you will learn in this Module: The various types of cost a firm faces, including fixed cost, variable cost, and total cost How a firm s costs generate marginal cost curves and average cost curves A fixed cost is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input. A variable cost is a cost that depends on the quantity of output produced. It is the cost of the variable input. The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output. Module Firm Costs From the Production Function to Cost Curves Now that we have learned about the firm s production function, we can use that knowledge to develop its cost curves. To see how a firm s production function is related to its cost curves, let s turn once again to George and Martha s farm. Once George and Martha know their production function, they know the relationship between inputs of labor and land and output of wheat. But if they want to maximize their profits, they need to translate this knowledge into information about the relationship between the quantity of output and cost. Let s see how they can do this. To translate information about a firm s production function into information about its cost, we need to know how much the firm must pay for its inputs. We will assume that George and Martha face either an explicit or an implicit cost of \$ for the use of the land. As we learned previously, it is irrelevant whether George and Martha must rent the land for \$ from someone else or whether they own the land themselves and forgo earning \$ from renting it to someone else. Either way, they pay an opportunity cost of \$ by using the land to grow wheat. Moreover, since the land is a fixed input for which George and Martha pay \$ whether they grow one bushel of wheat or one hundred, its cost is a fixed cost, denoted by FC a cost that does not depend on the quantity of output produced. In business, a fixed cost is often referred to as an overhead cost. We also assume that George and Martha must pay each worker \$2. Using their production function, George and Martha know that the number of workers they must hire depends on the amount of wheat they intend to produce. So the cost of labor, which is equal to the number of workers multiplied by \$2, is a variable cost, denoted by VC a cost that depends on the quantity of output produced. Adding the fixed cost and the variable cost of a given quantity of output gives the total cost, or TC, of that quantity of output. We can express the relationship among fixed cost, variable cost, and total cost as an equation: or (-) Total cost = Fixed cost + Variable cost TC = FC + VC 48 section Behind the Supply Curve: Profit, Production, and Costs

2 The table in Figure. shows how total cost is calculated for George and Martha s farm. The second column shows the number of workers employed, L. The third column shows the corresponding level of output, Q, taken from the table in Figure 4.. The fourth column shows the variable cost, VC, equal to the number of workers multiplied by \$2. The fifth column shows the fixed cost, FC, which is \$ regardless of the quantity of wheat produced. The sixth column shows the total cost of output, TC, which is the variable cost plus the fixed cost. The first column labels each row of the table with a letter, from A to I. These labels will be helpful in understanding our next step: drawing the total cost curve, a curve that shows how total cost depends on the quantity of output. George and Martha s total cost curve is shown in the diagram in Figure., where the horizontal axis measures the quantity of output in bushels of wheat and the vertical axis measures total cost in dollars. Each point on the curve corresponds to one row of the table in Figure.. For example, point A shows the situation when workers are employed: output is, and total cost is equal to fixed cost, \$. Similarly, point B shows the situation when worker is employed: output is 9 bushels, and total cost is \$6, equal to the sum of \$ in fixed cost and \$2 in variable cost. Like the total product curve, the total cost curve slopes upward: due to the increasing variable cost, the more output produced, the higher the farm s total cost. The total cost curve shows how total cost depends on the quantity of output. figure. Total Cost Curve for George and Martha s Farm The table shows the variable cost, fixed cost, and total cost for various output quantities on George and Martha s -acre farm. The total cost curve shows how total cost (measured on the vertical axis) depends on the quantity of output (measured on the horizontal axis). The labeled points on the curve correspond to the rows of the table. The total cost curve slopes upward because the number of workers employed, and hence total cost, increases as the quantity of output increases. The curve gets steeper as output increases due to diminishing returns to labor. Cost \$2,,8,6,,2, A B C D E Total cost, TC I H G F Quantity of wheat (bushels) Point on graph Quantity of labor L (workers) Quantity of wheat Q (bushels) Variable cost VC Fixed cost FC Total cost TC = FC + VC A B C D E F G H I \$ O 2 6 8,,2,,6 \$ \$ 6 8,,2,,6,8 2, module Firm Costs 49

3 But unlike the total product curve, which gets flatter as employment rises, the total cost curve gets steeper. That is, the slope of the total cost curve is greater as the amount of output produced increases. As we will soon see, the steepening of the total cost curve is also due to diminishing returns to the variable input. Before we can see why, we must first look at the relationships among several useful measures of cost. Two Key Concepts: Marginal Cost and Average Cost We ve just learned how to derive a firm s total cost curve from its production function. Our next step is to take a deeper look at total cost by deriving two extremely useful measures: marginal cost and average cost. As we ll see, these two measures of the cost of production have a somewhat surprising relationship to each other. Moreover, they will prove to be vitally important in later modules, where we will use them to analyze the firm s output decision and the market supply curve. Marginal Cost Module 3 explained that marginal cost is the added cost of doing something one more time. In the context of production, marginal cost is the change in total cost generated by producing one more unit of output. We ve already seen that marginal product is easiest to calculate if data on output are available in increments of one unit of input. Similarly, marginal cost is easiest to calculate if data on total cost are available in increments of one unit of output because the increase in total cost for each unit is clear. When the data come in less convenient increments, it s still possible to calculate marginal cost over each interval. But for the sake of simplicity, let s work with an example in which the data come in convenient one-unit increments. Selena s Gourmet Salsas produces bottled salsa; Table. shows how its costs per day depend on the number of cases of salsa it produces per day. The firm has a fixed table. Costs at Selena s Gourmet Salsas Quantity of salsa Variable Q Fixed cost cost Total cost (cases) FC VC TC = FC + VC \$ \$ \$ , ,8 \$,38 Marginal cost of case MC = ΔTC/ΔQ \$ section Behind the Supply Curve: Profit, Production, and Costs

4 figure.2 Total Cost and Marginal Cost Curves for Selena s Gourmet Salsas (a) Total Cost (b) Marginal Cost Cost \$,,2, 8 2nd case of salsa increases total cost by \$36. 8th case of salsa increases total cost by \$8. TC Cost of case \$2 2 MC Quantity of salsa (cases) Quantity of salsa (cases) Panel (a) shows the total cost curve from Table.. Like the total cost curve in Figure., it slopes upward and gets steeper as we move up it to the right. Panel (b) shows the marginal cost curve. It also slopes upward, reflecting diminishing returns to the variable input. cost of \$ per day, shown in the second column, which is the daily rental cost of its food-preparation equipment. The third column shows the variable cost, and the fourth column shows the total cost. Panel (a) of Figure.2 plots the total cost curve. Like the total cost curve for George and Martha s farm in Figure., this curve slopes upward, getting steeper as quantity increases. The significance of the slope of the total cost curve is shown by the fifth column of Table., which indicates marginal cost the additional cost of each additional unit. The general formula for marginal cost is: or Change in total cost generated by Change in total cost (-2) Marginal cost = = one additional unit Change in quantity of output of output MC = ΔTC ΔQ As in the case of marginal product, marginal cost is equal to rise (the increase in total cost) divided by run (the increase in the quantity of output). So just as marginal product is equal to the slope of the total product curve, marginal cost is equal to the slope of the total cost curve. Now we can understand why the total cost curve gets steeper as it increases from left to right: as you can see in Table., marginal cost at Selena s Gourmet Salsas rises as output increases. And because marginal cost equals the slope of the total cost curve, a higher marginal cost means a steeper slope. Panel (b) of Figure.2 shows the marginal cost curve corresponding to the data in Table.. Notice that, as in Figure 3., we plot the marginal cost for increasing output from to case of salsa halfway between and, the marginal cost for increasing output from to 2 cases of salsa halfway between and 2, and so on. istockphoto module Firm Costs

5 Average total cost, often referred to simply as average cost, is total cost divided by quantity of output produced. Why does the marginal cost curve slope upward? Because there are diminishing returns to inputs in this example. As output increases, the marginal product of the variable input declines. This implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises. And since each unit of the variable input must be paid for, the additional cost per additional unit of output also rises. Recall that the flattening of the total product curve is also due to diminishing returns: if the quantities of other inputs are fixed, the marginal product of an input falls as more of that input is used. The flattening of the total product curve as output increases and the steepening of the total cost curve as output increases are just flip-sides of the same phenomenon. That is, as output increases, the marginal cost of output also increases because the marginal product of the variable input decreases. Our next step is to introduce another measure of cost: average cost. Average Cost In addition to total cost and marginal cost, it s useful to calculate average total cost, often simply called average cost. The average total cost is total cost divided by the quantity of output produced; that is, it is equal to total cost per unit of output. If we let ATC denote average total cost, the equation looks like this: Total cost (-3) ATC = = Quantity of output TC Q Average total cost is important because it tells the producer how much the average or typical unit of output costs to produce. Marginal cost, meanwhile, tells the producer how much one more unit of output costs to produce. Although they may look very similar, these two measures of cost typically differ. And confusion between them is a major source of error in economics, both in the classroom and in real life. Table.2 uses data from Selena s Gourmet Salsas to calculate average total cost. For example, the total cost of producing 4 cases of salsa is \$3, consisting of \$ in fixed cost and \$92 in variable cost (from Table.). So the average total cost of producing 4 cases of salsa is table.2 Average Costs for Selena s Gourmet Salsas Quantity of salsa Total Average total Average fixed Average variable Q cost cost of case cost of case cost of case (cases) TC ATC = TC/Q AFC = FC/Q AVC = VC/Q \$2 \$2. \$. \$ , , section Behind the Supply Curve: Profit, Production, and Costs

6 \$3/4 = \$7. You can see from Table.2 that as the quantity of output increases, average total cost first falls, then rises. Figure.3 plots that data to yield the average total cost curve, which shows how average total cost depends on output. As before, cost in dollars is measured on the vertical axis and quantity of output is measured on the horizontal axis. The average total cost curve has a distinctive U shape that corresponds to how average total cost first falls and then rises as output increases. Economists believe that such U-shaped average total cost curves are the norm for firms in many industries. figure.3 Average Total Cost Curve for Selena s Gourmet Salsas The average total cost curve at Selena s Gourmet Salsas is U-shaped. At low levels of output, average total cost falls because the spreading effect of falling average fixed cost dominates the diminishing returns effect of rising average variable cost. At higher levels of output, the opposite is true and average total cost rises. At point M, corresponding to an output of three cases of salsa per day, average total cost is at its minimum level, the minimum average total cost. Cost of case \$ M Minimum average total cost Average total cost, ATC Section Behind the Supply Curve: Profit, Production, and Costs Quantity of salsa (cases) Minimum-cost output To help our understanding of why the average total cost curve is U-shaped, Table.2 breaks average total cost into its two underlying components, average fixed cost and average variable cost. Average fixed cost, or AFC, is fixed cost divided by the quantity of output, also known as the fixed cost per unit of output. For example, if Selena s Gourmet Salsas produces 4 cases of salsa, average fixed cost is \$/4 = \$27 per case. Average variable cost, or AVC, is variable cost divided by the quantity of output, also known as variable cost per unit of output. At an output of 4 cases, average variable cost is \$92/4 = \$48 per case. Writing these in the form of equations: Fixed cost (-4) AFC = = Quantity of output FC Q Variable cost AVC = = Quantity of output VC Q Average total cost is the sum of average fixed cost and average variable cost; it has a U shape because these components move in opposite directions as output rises. Average fixed cost falls as more output is produced because the numerator (the fixed cost) is a fixed number but the denominator (the quantity of output) increases as more is produced. Another way to think about this relationship is that, as more output is produced, the fixed cost is spread over more units of output; the end result is that the A U-shaped average total cost curve falls at low levels of output and then rises at higher levels. Average fixed cost is the fixed cost per unit of output. Average variable cost is the variable cost per unit of output. module Firm Costs 3

10 But once there are enough workers to have completely exhausted the benefits of further specialization, diminishing returns to labor set in and the marginal cost curve changes direction and slopes upward. So typical marginal cost curves actually have the swoosh shape shown by MC in Figure.6. For the same reason, average variable cost curves typically look like AVC in Figure.6: they are U-shaped rather than strictly upward sloping. However, as Figure.6 also shows, the key features we saw from the example of Selena s Gourmet Salsas remain true: the average total cost curve is U-shaped, and the marginal cost curve passes through the point of minimum average total cost. Module Solutions appear at the back of the book. Check Your Understanding AP R eview. Alicia s Apple Pies is a roadside business. Alicia must pay \$9. in rent each day. In addition, it costs her \$. to produce the first pie of the day, and each subsequent pie costs % more to produce than the one before. For example, the second pie costs \$.. = \$. to produce, and so on. a. Calculate Alicia s marginal cost, variable cost, average fixed cost, average variable cost, and average total cost as her daily pie output rises from to 6. (Hint: The variable cost of two pies is just the marginal cost of the first pie, plus the marginal cost of the second, and so on.) b. Indicate the range of pies for which the spreading effect dominates and the range for which the diminishing returns effect dominates. c. What is Alicia s minimum-cost output? Explain why making one more pie lowers Alicia s average total cost when output is lower than the minimum-cost output. Similarly, explain why making one more pie raises Alicia s average total cost when output is greater than the minimum-cost output. Section Behind the Supply Curve: Profit, Production, and Costs Tackle the Test: Multiple-Choice Questions. 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. 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 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 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.. Q VC TC \$ \$ On the basis of the data in the table above, what is the marginal cost of the third unit of output? a. 4 b. c. 6 d. 9 e. 3 module Firm Costs 7

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