I. Short-Run Costs. A. Total Fixed Costs (TFC) University of Pacific-Economics 53 Lecture Notes #8A

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1 University of Pacific-Economics 53 Lecture Notes #A I. Short-Run Recall that the goal of the firm is to maximize profit. In order to determine profits, firms must calculate total costs. In this chapter we will examine in detail what these costs are in the shortrun. The short-run is a time period in which at least one input is fixed and firms cannot enter or leave the industry. There are two types of short-run costs Fixed (TFC) (TVC) Together they determine total costs (TC) TC = TFC + TVC A. Fixed (TFC) fixed costs (also called overhead) are costs that doesn t depend on the level of output. Even if the firm stops producing, these costs still have to be paid in the short-run. A typical example of a fixed cost is an office lease. Typically, firms sign long-term contracts that require them to pay rent for the term of the lease. The firm will still have to pay the same rent no matter how much they produce. Table 1 shows the short-run fixed costs for a hypothetical firm. Note that regardless on the quantity produced the fixed cost is the same at $1. Figure 1 graphically illustrates the shape of the TFC curve. Table 1: Fixed Cost Quantity of units of Output Produced Fixed Cost (TFC)

2 Figure 1: Fixed 1 1 Fixed (in $) TFC 1 1 Fixed (AFC) is the total fixed costs divided by units of output produced. AFC = TFC/Q Where Q = units of output produced Table includes the calculated AFC. Figure shows a graphical representation of AFC. Table : Fixed Quantity Fixed Cost (TFC) Fixed (AFC)

3 Figure 1 (in $) 1 AFC 1 1 Note that AFC falls as output increases, this is known as spreading overhead. The term comes from the fact that the fixed costs is being spread over larger and larger number of units. B. (TVC) variable costs are the costs that vary with the level of output in the short-run. When firms increase production, total variable costs will increase. When firms decrease production, total variable costs will go down. Table 3 shows the same hypothetical firm from the previous examples with variable costs included. Table 3: Quantity Fixed Cost (TFC) Fixed (AFC) (TVC) Note that in Table 3 when the firm is not producing anything, total variable costs are. As production increases the variable costs increases as well. We can represent the total variable costs in graphical form. Figure 3 graphically illustrates a total variable curve.

4 Figure 3 (in $) TVC 1 1 TVC The total variable cost curve assumes that at each output, the firm is choosing the best technology. In other words at each level of output, the firm is choosing the technology that results in the least cost. (AVC) is the total variable costs divided by the units of output produced. AVC = TVC/Q Where Q = units of output produced Table : Quantity Fixed Cost Fixed (TFC) (TVC) (AVC) (AFC) Figure illustrates the graphical representation of the AVC curve

5 Figure (in $) AVC 1 1 AVC C. Marginal Cost (MC) Although firms calculate total fixed costs and total variable costs, the most important cost calculation is something called marginal cost (MC). Marginal cost is the increase in total cost that occurs with the production of an additional unit of output. If a firm had produced 1 units, the marginal cost would be the increase in total costs that would result from the production of the 11 st unit. Since fixed costs won t be affected by the production of one more unit of output, marginal cost really just measures the change in total variable cost when the extra unit produced. Table 5: Marginal Quantity Fixed Cost (TFC) Fixed (AFC) (TVC) (AVC) Marginal Cost (MC)

6 Table adds marginal cost to our table of costs for the hypothetical firm. When the firm increases output from units to 1 units, the increase in total variable cost is 5. Marginal cost is thus 5. When the firm increases from 1 unit of output to unit of output, total variable costs goes from $5 to $. The increase in total variable costs that results from the production of the nd unit is $3. Likewise when the firm increases from units of output to 3 units of output, total variable costs goes from $ to $1. The increase in total variable costs is $, thus the marginal cost is $ and so on. Figure 5 provides a graphical representation of a typical marginal cost curve. Figure 5 Marginal Cost (in $) MC 1 1 Note the shape of the marginal cost curve. Initially, the marginal cost curve decreases, but after some point the marginal cost curve increases. This should make some intuitive sense. Think about a pizza shop that only has hired 1 worker. That worker has to not only make the pizza, but also answer the phones, take customer orders, clean the table, etc By hiring a second worker, the pizza shop will free up the first worker to focus on making pizzas, while the nd worker handles the other duties. Thus the pizza shop could increase the number of pizzas produced (become more productive) and thus marginal costs may decline. However, as we saw in Chapter 7, adding additional workers will eventually result in diminishing marginal product because the capital (number of pizza ovens, shop size, etc..) is fixed. Since we re in the short-run, there will always be some fixed factor of production that will set a limit on how much a firm can produce. As the firm reaches closer to that limit, the costs for the firm will steadily increase. After a certain point, marginal costs will increase with output in the short run. 1. Relationship Between and Marginal Cost Recall that the slope is the change in the Y-axis variable over the change in the X-axis variable. For total variable cost the slope is equal to ( TVC/ Q). But as we saw the marginal cost is just the change in total variable costs ( TVC) when output is increased by 1 unit ( Q=1). Marginal Cost = ( TVC/1) Marginal Cost (MC) = TVC Marginal Cost is the slope of the total variable cost curve. MC. Relationship between and Marginal Cost

7 When we talked about average product and marginal product in Chapter 7 we developed an important relationship between the marginal and average concept. We learned that when the marginal is above the average, the average will rise. Conversely when the marginal is below the average, the average will fall. We can see this relationship clearly when we graph both the average variable cost curve and the marginal cost curve on the same graph as we have done in Figure. Figure : Relationship between AVC and MC (in $) 9 As we can see when the marginal cost curve is below 7 the AVC curve, the AVC curve is being 5 dragged down, at some point the MC AVC curve will cross the 3 MC AVC. Once MC curve is greater 1 than the AVC curve, the AVC 1 1 will be lifted up by the higher marginal curve. The key thing to note is that the marginal cost curve will always intersect the average variable cost at its minimum point. This should make complete sense. Since if MC is below AVC, AVC should be falling, but once it crosses the AVC curve then it will stop decreasing and start increasing. If any of this is unclear or confusing, you should stop and review the discussion on average vs. marginal that was presented in Ch. 7. D. (TC) costs (TC) is simply total variable costs plus total fixed costs. TC = TFC + TVC Cost (ATC) is the total cost divided by the number of units produced. ATC = TC/Q Where Q = quantity of units produced. ATC can also be calculated another way. Since TC = TFC + TVC we can divide both sides by Q. To get (TC/Q) = (TFC/Q) + (TVC/Q) which by definition equals ATC = AFC + AVC

8 Table : Quantity Marginal Fixed Fixed Cost Cost (MC) (TC) (TFC) (AFC) (TVC) (AVC) (ATC) Figure 7: Cost Curve (in $) TFC TVC TC The total cost curve involves simply adding the total fixed cost and total variable cost. It will have the same shape as the TVC, the only difference being that it is higher by the amount of the TFC. Figure puts all the average costs curves together along with the marginal costs.

9 Figure : Cost Curves and Marginal AFC AVC MC ATC 1 1 If you look carefully at the cost curves we have drawn you should notice certain properties regarding the curves. If you were asked to reproduce the cost curves, you will have to make sure that the following rules were followed. Rule #1: The marginal cost curve intersects both the AVC and ATC curves at their minimum points. Again this makes sense because as long as the MC curve is below either the AVC or ATC curves those curves will be decreasing. In is only when the MC curve is above the AVC and ATC curves, will those curves start increasing. When MC=AVC or when MC = ATC, they must be at their lowest point. Rule #: As output increases, AFC gets smaller and smaller. This is the spreading of overhead property. Rule #3: As output increases, the difference between ATC and AVC cost decreases. This occurs because of Rule #. As output increases AFC gets smaller, so the difference between ATC and AVC also gets smaller. Note that AFC will never go to, thus there will always be a difference between ATC and AVC. ATC and AVC will never cross. Rule #: AVC and ATC are generally U-Shaped in that they fall initially at low levels of output, and then increase as output increases. AVC falls because of specialization early in the production process. However as we increase output, it takes more and more input to get the same amount of output, which increases costs (the law of diminishing returns). Rule #5: MC curve will generally fall in the beginning for a short while, and then increase. It is generally a J-Shaped curve.