THE CONSTANT COST FIRM Let’s imagine a simple firm (business) whose costs we can describe with just two numbers: Total Fixed Cost (TFC) and Variable Cost per unit (v or vcpu) Variable Cost per unit will actually have a variety of names: It can appear as v or vcpu as well as AVC (average variable cost) or MC (marginal cost)

THE CONSTANT COST FIRM Total Fixed Costs (or just “Fixed Cost”) includes all the costs that must be paid regardless of how much the firm produces. These costs are often called “overhead.” Examples of fixed cost are rent and interest payments (i.e. the costs of land and capital) For our example firm, let’s suppose these costs are $24,000 per month.

THE CONSTANT COST FIRM – Fixed Costs We could now compute Average Fixed Cost, the portion of fixed cost attributable to each unit of output. Using TFC = $24,000, if the firm produced 10 units in a month (Q = 10) then Average fixed cost is AFC = $24,000÷10 units = $2,400 per unit If the firm produced 100 units, then Average fixed cost is AFC = $24,000÷100 units = $240 per unit

Average Fixed Costs (fixed cost per unit) It is always true that as output rises, average fixed cost (AFC) decreases. See the following table. “Q” designates the output of the firm. QAFC Let Total Fixed Cost (TFC) equal $24,000 per month. Compute AFC for each Q, then click for the correct answer. The formula is AFC = TFC ÷ Q This is a “trick”. You can’t compute an average when Q is 0. (You’re not allowed to divide by zero.) ### ,000 ÷ 100 = $240 per unit ,000 ÷ 200 = $120 per unit ,000 ÷ 300 = $80 per unit ,000 ÷ 400 = $60 per unit ,000 ÷ 500 = $48 per unit ,000 ÷ 600 = $40 per unit You can see that as output (Q) gets larger, AFC gets smaller. We are “spreading” the overhead of $24,000 over more units of output, making each unit “carry” less of the fixed cost.

Now let’s graph the information from the previous table. QAFC OK, we can’t graph this one! The point shows a quantity of 100 and a fixed cost per unit of $240. A quantity of 200, AFC of 120 Q = 300, AFC = 80 And now connect the dots First notice the labels on the axes. The horizontal axis measures “Q” – the quantity of the firm’s output. The vertical axis measures “$/Q” – dollars per unit. This combination of axis labels – Q and $/Q -- will be very common.

We rarely need to use actual numbers. What we want is a basic picture of AFC. $/Q Q Draw the axes Label the axes Draw the curve Properties of the curve 1. Starts high and falls fast, but then almost levels off. 2. Never gets to zero. That is, it gets close to, but never reaches, the axes. Label the curve AFC Learn to draw this picture! Include all the labels every time. AVERAGE FIXED COST (AFC)

Variable Cost per Unit We looked at a firm’s fixed costs. The second type of cost is variable costs, those costs which change as the firm produces more or less. The most common types of variable costs are wages and raw materials. To keep our example very simple for the moment, we will assume that there is a given, constant variable cost per unit. For our example let’s say that each unit of output costs $60 in variable cost of materials and labor.

Graphing variable cost per unit in this simple case (v = $60) ought to be pretty easy. $/Q Q Draw the axes Label the axes Note the same labels as we used before. Draw the curve Label the curve Learn to draw this picture! Include all the labels every time. v 60 Again, this curve will get many names: v, vcpu, AVC or MC The flat line says that v is $60 at any level of output (Q).

$/Q Q v 60 ATC is the sum of AFC and v. We add graphically by raising AFC by the amount of v. Now let’s combine the two per-unit costs, fixed and variable, to get average total cost (ATC), which we could also just call “cost per unit.” AFC ATC The distance is equal to v, so that ATC = AFC + v.

Actually the picture we will want most shows only v and ATC. That is: ATC v Q $/Q This will be an important picture. Learn to sketch it, including all the labels.

THAT’S ALL FOR NOW