Author: John Bouman

What are the Relationships Between the Various Costs? Section 3 provides definitions of the important economic costs. Below is a list of the relationships between these costs. Using the abbreviations from the previous section, and using Q as the number of goods or services produced, we have 1. TVC + TFC = TC 2. AVC = TVC/Q 3. AFC = TFC/Q 4. ATC = TC/Q 5. MC = change in TC/change in Q Examples  Example 1 Problem: Let’s suppose that fixed costs are $300 and variable costs are $900. What is total cost? Solution: Total cost = $300 + $900 = $1,200 Example 2 Problem: Let’s suppose that you produce 50 bushels of apples, and you use the costs from Example 1. What are average variable costs and average fixed costs? Solution: AVC = $900/50 = $18, and AFC = $300/50 = $6 Example 3 Problem: In the above example, what is average total cost? Solution: ATC = $1,200/50 = $24 Example 4 Problem: If you increase your production by 5 bushels, and your total cost increases by $60, what is your marginal cost? Solution : MC = $60/5 = $12 Example 5 Problem: In the following table, a firm has a choice of producing from zero to 4 products. We know some of the costs. Can you calculate the missing values? Q TC TFC TVC ATC AFC AVC...

Graphing Cost Data from a Table In the previous section, we learned how to calculate cost data. Below we will plot the data in a graph. The next diagram shows a hypothetical firm’s total cost, total variable cost, and total fixed cost curves. The shape of the curves represent typical shapes of real world firms’ cost curves. Note that in the above diagram, total fixed cost is constant at $50 for all levels of production, whereas total cost and total variable cost increase with higher levels of output. Total fixed cost plus total variable cost always equals total cost. For example, at output 6, total fixed cost equals $50 and total variable cost equals $100. Therefore, total cost equals $150. The diagram below shows typical average and marginal cost curves of a firm. Note that the marginal cost curve starts at a relatively high value, then decreases steeply. At output 4, it reaches a minimum, and then it increases steeply. The average variable cost and average total cost curves also decrease first, then increase, but they do so more gradually. Spreading the Overhead The average fixed cost curve decreases continuously. This is because average fixed cost is total fixed cost divided by output. Dividing a fixed number by increasingly large numbers of output results in smaller and smaller numbers. When firms produce larger and larger quantities of output, they...

Derivation of the Long-Run Average Cost Curve A firm’s long-run average cost curve is derived from its short-run average cost curves. For each short-run fixed plant size, we take the lowest or near-lowest costs for that size plant. These bottom portions of the different short-run cost curves make up the long-run average cost curve. Therefore, a firm’s long-run average cost curve is the “envelope” of the bottom points of the firm’s short-run average cost curves. In the long run, all inputs are variable, and the firm has the choice of operating at a variety of plant or facility sizes. A small operation (SRAC1) that produces 300 units faces average costs of $26. A larger one, which produces 700 units (SRAC3), can lower its average costs to $17. When the firm gets too large (SRAC6), average costs rise to $20. Economies and Diseconomies of Scale When a firm increases its output and notices that its average total costs decrease (the downward portion of the long-run average cost curve), it experiences economies of scale. When a firm increases its output and observes increasing average total costs (the upward portion of the long-run average cost curve), it experiences diseconomies of scale. Economies and diseconomies of scale are related to increasing and decreasing returns to scale. These are explained in the next section. Video Explanation For a video explanation of the long-run average...

Increasing Returns to Scale Increasing returns to scale is closely associated with economies of scale (the downward sloping part of the long-run average total cost curve in the previous section). Increasing returns to scale occurs when a firm increases its inputs, and a more-than-proportionate increase in production results. For example, in year one a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs doubled), and produces 2,500 products (output more than doubled). When input prices remain constant, increasing returns to scale results in decreasing long-run average costs (economies of scale). A firm that gets bigger experiences lower costs because of increased specialization, more efficient use of large pieces of machinery (for example, use of assembly lines), volume discounts, and other advantages of producing in large quantities. Usually these lower costs translate into lower product prices for consumers, higher wages for the employees, and higher profits for the owners. Decreasing Returns to Scale Decreasing returns to scale is closely associated with diseconomies of scale (the upward part of the long-run average total curve). Decreasing returns to scale happens when the firm’s output rises proportionately less than its inputs rise. For example, in year one, a firm employs 200 workers, uses 50 machines, and produces 1,000 products. In year two it employs 400 workers, uses 100 machines (inputs...

What’s in This Chapter? In this chapter we discuss four types of industries, each with varying degrees of competition. A purely competitive industry is most competitive. A monopolistically competitive industry is very competitive, but each firm has a small degree of monopoly power. An oligopoly industry is an industry in which only a small number of firms dominate the market. A monopoly is an industry with only one seller. We also learn about the characteristics and profit maximizing behaviors of purely competitive industries. In the next unit (7), we look at characteristics and behaviors of monopolies. In Unit 8 we study monopolistically competitive and oligopoly industries. Economists use these industry models to explain behaviors of industries with varying degrees of competition and to draw important conclusions for policy-making purposes. We discover that competition is essential in a well-functioning economy. It prevents prices from becoming excessive. In a competitive market, businesses will fail if they charge prices that are much higher than the competition. The Internet, despite some of its drawbacks, has helped increase competition in many industries. Buyers can more easily shop for millions of products, and immediately know most of their qualities and prices. Many businesses use the Internet at a relatively low cost. This increases competition and promotes efficiency and lower...