Cost – The Root of Supply Total Cost Average Cost Marginal Cost Fixed Cost Variable Cost Long Run Average Costs Economies of Scale

Overview of Cost When thinking about production, the goal is to find the most efficient and productive point to produce – and while this should be the goal of any business or any economic endeavor - ultimately cost is the main factor in making economic decisions about production. Logically, cost should be closely connected to production. Everything used in production has a cost – as shown in the previous section the cost of labor is the wage rate and the cost of capital is the rental rate. When making production decisions companies do consider these costs and compare them to the amount produced.

Total Cost In the short run companies have to work with the fixed capital and variable labor, and in the interest of competitiveness, employ the most productive ratio of capital to labor. As a result, total cost is shown in relation to the amount of goods produced. A total cost function for a company can be shown by the following equation: TC = f (Q P ) Total cost is a function of quantity produced

Average Cost & Marginal Cost AC = TC Average cost is the total cost Q P divided by the quantity produced. This is the cost per unit. MC = f’(Q P ) = d TC Marginal cost is how producing an d Q P additional unit changes total cost.

Relationship Between Total, Average & Marginal Cost The total cost curve shows he connection between cost and production. Considering the marginal product curve, marginal cost explains shape of the total cost curve All workers cost the same. As workers become more productive (before the point of diminishing marginal returns) the marginal cost go down, and the total cost curve becomes less steep. When workers are added beyond the point of diminishing marginal returns, they contribute less to total product – yet cost the same. Point of Diminishing Marginal Returns

Relationship Between Marginal & Average Cost Surprisingly, while the marginal cost curve is increasing the average cost curve continues to decline for a short period. This shows that while the additional workers add less to the total product, the company continues to become more cost efficient – the cost per unit it lower. Only after the marginal cost had grown larger than the average cost has the company become less cost efficient. Point of Lowest Average Cost

Fixed and Variable Cost Total Cost can also be divided into fixed and variable cost. TC = FC + VC Fixed Costs - The cost for simply being in business – start up costs, capital costs, and necessary fees. These are the costs a company must pay, even when it is producing nothing. Fixed costs have no effect on the quantity produced. In the short run, capital could be considered a fixed cost (ie – companies must pay the rental fee even if they do not use the machine). Variable Costs - The cost associated with producing goods and that change with the quantity of goods produced - the costs of inputs in the production that are directly connected to the quantity produced, such as labor and materials.

Relationship Between Total, Variable & Fixed Costs

Consider the total cost curve shown in the equation below. Answer the following questions: TC = Q – 7.5 Q 2 + Q 3 What is the fixed cost for this firm? What is the marginal cost equation for this firm? What is the average cost equation for this firm? At what quantity is the marginal cost equal to the average total cost?

Costs in the Long Run In the long run a company can plan for its optimal size – which economists refer to as scale. This implies choice, but often, because of competition or the nature of an industry, companies do not have much choice in. In many markets, true competitors tend to be about the same size. This is because of economies of scale. This idea is similar to business decisions in the short run, where companies operate at the point where average cost is at its lowest point - lowest per unit cost. In the long run, a company can adjust its capital and labor to the most productive at cost ratio. A growing company becomes more efficient and can spread its costs over a larger quantity of output. This growth, matched with lower average costs is called economies of scale. However, beyond a certain point, a growing company becomes too large and difficult to manage, which results in higher average costs. If a company expands beyond its ability of produce efficiently, the company experiences diseconomies of scale.

Short Run to Long Run Cost The graph to the right shows two short run cost curves (one a small plant and a medium sized plant) it is clear how the larger plant has lower average costs. This is because it can take advantage of more specialization and production efficiencies to lower its average cost. The low cost points of the short run average cost curves can be connected to form a long average cost curve. Clearly a company that can operate with the lowest average cost will have a competitive advantage – this is economies of scale.

Long Run Cost – Economies of Scale The graph to the right shows the Long Run Average Total Cost Curve for a company – the short run average total costs (SRATC) are imposed upon it.. This “u” shape to the curve is based on the changes a company goes through as it increases its scale of production.