Firm Costs Module KRUGMAN'S MICROECONOMICS for AP* 19 55 Micro: Econ: Margaret Ray and David Anderson

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 The purpose of this module is to use the concept of the production function to introduce the short-run cost curves facing a firm. These cost curves are key to seeing how economic profits, or losses, are generated

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. To hire inputs for production, the firm will incur production costs which we represent with cost curves. We will use the cost curves we develop in this module over and over throughout the rest of the course. Drawing graphs with these curves is a central part of the AP exam. Understanding cost curves is crucial to understanding important microeconomic models in the remaining modules. We will refer to a variety of different costs. Become comfortable with the abbreviations you will see: T: total V: variable F: fixed A: average M: marginal

Total Costs Fixed costs (FC) are costs whose total does not vary with changes in output. These are the payments to the fixed inputs in the production function. Variable costs (VC) are costs that change with the level of output. These are the payments to the variable inputs in the production function. Total cost (TC) is the sum of total fixed and total variable costs at each level of output. TC = FC + VC 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. What will we see if we graph these cost curves? When drawing cost curves, cost is measured on the vertical axis and output (Q) is on the horizontal axis. This is different than the labels on the production function graphs in the previous modules.   TFC will a horizontal line (the level stays the same regardless of the output produced). We will also see that fixed costs are paid even when zero output is produced. The TVC curve rises as more output is produced and it begins to rise more and more quickly at higher levels of output. The TC curve has the same shape as the TVC because it is simply the TVC plus a constant level of TFC. This means that the vertical distance between TC and TVC is always TFC

MC = ΔTC/ΔQ = Δ(VC + FC)/ΔQ = ΔVC/ΔQ Marginal cost MC is the additional cost of producing one more unit of output. MC = ΔTC/ΔQ = Δ(VC + FC)/ΔQ = ΔVC/ΔQ Remind the students that, in the last module, marginal product was shown to be the slope of total product. The same is true here. Marginal cost is the slope of total cost or total variable cost curve. Why does MC initially decline, but eventually increases as more output is produced? The diminishing returns to labor in the production function cause this to occur.   As output increases, the marginal product of the variable input (labor) declines. This implies that more and more labor must be used to produce each additional unit of output. And since each unit of the labor must be paid for, the additional cost per additional unit of output also rises. What do we see when we graph the MC curve? MC can fall initially due to specicializtion of labor in the prodcution 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.

ATC = TC/Q AVC = TVC/Q AFC = TFC/Q Average Cost Average (AC) is the total cost divided by the level of output (it is also called average cost, unit cost, or per unit cost). ATC = TC/Q AVC = TVC/Q AFC = TFC/Q Since TC = TFC + TVC, ATC= AFC + AVC  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.    What do we see when we graph these curves? 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 fixed costs are 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. 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.

The relationship between MC and AC The MC curve intersects the U-shaped ATC and AVC at their respective minimum points. If the next (or marginal) value is above the average, it pulls the average up If the next (or marginal) value is below the average, it pulls the average down. If the next (or marginal) value is above the average, it pulls the average up If the next (or marginal) value is below the average, it pulls the average down. Therefore; The AC will fall as long as the MC<AC. As soon as the MC rises so that MC>AC, the AC will begin to rise. If the MC of the next unit is equal to the current AC, AC will not change.  

Figure 55.1 Total Cost Curve for George and Martha’s Farm Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Table 55.1 Costs at Selena’s Gourmet Salsas Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 55.2 Total Cost and Marginal Cost Curves for Selena’s Gourmet Salsas Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Table 55.2 Average Costs for Selena’s Gourmet Salsas Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 55.3 Average Total Cost Curve for Selena’s Gourmet Salsas Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 55.4 Marginal Cost and Average Cost Curves for Selena’s Gourmet Salsas Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 55.5 The Relationship Between the Average Total Cost and the Marginal Cost Curves Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 55.6 More Realistic Cost Curves Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers