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Economic CostsEconomic Costs

By the end of this section, you By the end of this section, you should be able to…..should be able to…..

Define and calculate total cost, average cost, and Define and calculate total cost, average cost, and marginal cost.marginal cost.

Graphically depict the total cost, fixed costs and Graphically depict the total cost, fixed costs and variable cost curves.variable cost curves.

Discuss the difference between costs in the SR and in Discuss the difference between costs in the SR and in the LRthe LR

Know if you have economies of scale, diseconomies of Know if you have economies of scale, diseconomies of scale or negative economies of scale and what that scale or negative economies of scale and what that means.means.

Draw the LR cost curve.Draw the LR cost curve.

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Costs OverviewCosts Overview

Costs are looked at in different ways in the Costs are looked at in different ways in the short run and in the long run.short run and in the long run. The The short runshort run is a time period in which is a time period in which

producers are able to change the quantities of producers are able to change the quantities of some but not all of the resources they employ.some but not all of the resources they employ.

A firm can adjust the number of workers but not the A firm can adjust the number of workers but not the plant’s capacity in the short run.plant’s capacity in the short run.

The The long runlong run is a time period sufficiently long is a time period sufficiently long to enable producers to change the quantities of to enable producers to change the quantities of allall the resources they employ. the resources they employ.

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Short Run CostsShort Run Costs

Total Cost: the cost of all the factors of Total Cost: the cost of all the factors of production used by a firm.production used by a firm.

TC = FC + VCTC = FC + VC

Total Fixed Costs are the costs of Total Fixed Costs are the costs of fixed factors of production used by a fixed factors of production used by a firm. These factors can not be firm. These factors can not be changed in the short run. Examples changed in the short run. Examples include capital, cost of land, etc. include capital, cost of land, etc. ****There are no fixed costs in the ****There are no fixed costs in the long run.long run.

Total Variable Costs are the Total Variable Costs are the cost of the variable factors cost of the variable factors of production used by a of production used by a firm. Example quantity of firm. Example quantity of labor employed.labor employed.

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Total Cost CurvesTotal Cost CurvesTotal Costs

Output

Total Cost Curve=FC+VC

Fixed Cost Curve

Fixed Costs Amount

Variable Cost Curve

Variable Cost Amount at a given output.

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Average CostsAverage Costs

Q is quantity of output.Q is quantity of output. Average fixed costs: AFC=TFC/QAverage fixed costs: AFC=TFC/Q

Average fixed costs decline as output increases because the total Average fixed costs decline as output increases because the total fixed costs are spread over a larger and larger output.fixed costs are spread over a larger and larger output.

Average variable costs: AVC=TVC/QAverage variable costs: AVC=TVC/Q As added variable resources increase output, average variable As added variable resources increase output, average variable

cost declines initially, reaches a minimum, and then increases cost declines initially, reaches a minimum, and then increases again. As a result, AVC is U-shaped.again. As a result, AVC is U-shaped.

Average total costs: ATC=TC/Q=AFC+AVCAverage total costs: ATC=TC/Q=AFC+AVC Graphically, ATC can be found by vertically adding the AFC Graphically, ATC can be found by vertically adding the AFC

and AVC curves.and AVC curves.

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Total Costs vs. Average CostsTotal Costs vs. Average Costs

Total Costs look at the costs at a particular Total Costs look at the costs at a particular output level.output level.

Average Costs looks at the average amount of Average Costs looks at the average amount of each type of cost over all of the output each type of cost over all of the output produced up to a certain production amount.produced up to a certain production amount.

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Marginal CostMarginal Cost

Marginal Cost is the change in total cost that Marginal Cost is the change in total cost that results from a one unit increase in output.results from a one unit increase in output. It is the cost of producing one extra unit of output.It is the cost of producing one extra unit of output.

MC = TC = TC1 – TC2MC = TC = TC1 – TC2

QQ Q1 - Q2 Q1 - Q2 See how TC changes as output changes.See how TC changes as output changes.

Graphically, the MC curve intersects the AVC curve at its minimum…

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Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

Average and Marginal Cost CurvesAverage and Marginal Cost Curves

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Numeric ExampleNumeric Example

Example: Sam owns a Smoothie ShopExample: Sam owns a Smoothie Shop Suppose Sam produces 5 gallons an hour at a cost of $26.20 Suppose Sam produces 5 gallons an hour at a cost of $26.20

and produces 6 gallons of smoothies an hour at a total cost of and produces 6 gallons of smoothies an hour at a total cost of $28.00.$28.00.

Total CostsTotal Costs Total Cost at 5 Gallons = $26.20Total Cost at 5 Gallons = $26.20 Total Cost at 6 Gallons = $28.00Total Cost at 6 Gallons = $28.00

Average CostsAverage Costs Average Cost at 5 Gallons = $5.24 (=TC/Q=$26.20/5)Average Cost at 5 Gallons = $5.24 (=TC/Q=$26.20/5) Average Cost at 6 Gallons = $4.67 (=TC/Q=$28.00/6)Average Cost at 6 Gallons = $4.67 (=TC/Q=$28.00/6)

Marginal CostsMarginal Costs Marginal Cost at 6 Gallons = $1.80 (= TC/ Q=(28.00-26.20)/(6-5)Marginal Cost at 6 Gallons = $1.80 (= TC/ Q=(28.00-26.20)/(6-5)

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Long Run CostsLong Run Costs

In the Long Run, the firm can vary the In the Long Run, the firm can vary the quantity of labor (L) (variable in the short run) quantity of labor (L) (variable in the short run) and quantity of capital (K) (fixed in the short and quantity of capital (K) (fixed in the short run).run).

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Changing Amount of Labor and Changing Amount of Labor and Capital Could Cause 1 of 3 ThingsCapital Could Cause 1 of 3 Things

Economies of Scale: Output increases by an Economies of Scale: Output increases by an even higher % than the % a firm increases its even higher % than the % a firm increases its inputs (K and L) by.inputs (K and L) by.

Diseconomies of Scale: Output increases by a Diseconomies of Scale: Output increases by a smaller % than the % a firm increases its smaller % than the % a firm increases its inputs by.inputs by.

Constant Returns to Scale: Output increases by Constant Returns to Scale: Output increases by the same % that a firm increases its inputs by. the same % that a firm increases its inputs by.

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Long-Run ATC CurveLong-Run ATC Curve

Long-RunATC

Ave

rag

e T

ota

l C

ost

s ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

The long-run ATC curve just “envelopes” the short run ATCs

Economies of Scale where LRATC Curve is sloped downward

Diseconomies of Scale where LRATC Curve is sloped upward

Constant Returns to Scale where LRATC Curve is flat