However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change. Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
As explored in the chapter Choice in a World of Scarcity , fixed costs are often sunk costs that cannot be recouped. In thinking about what to do next, sunk costs should typically be ignored, since this spending has already been made and cannot be changed. Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. These costs are measured in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit.
In the previous example, they are measured as cost per haircut. It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average cost tells a firm whether it can earn profits given the current price in the market. Expanding the equation for profit gives:. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative.
The marginal cost of producing an additional unit can be compared with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how profits would be affected by increasing or decreasing production. The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an Internet company that provides medical advice to customers.
Such a company might be paid by consumers directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information.
In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space. For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter.
For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine maintenance of the equipment, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost.
However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Fixed costs are sunk costs; that is, because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing.
Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises. Marginal cost is calculated by taking the change in total cost or the change in variable cost, which will be the same thing and dividing it by the change in output, for each possible change in output.
Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit. Average total cost is calculated by taking total cost and dividing by total output at each different level of output.
Average costs are typically U-shaped on a graph. Average variable cost is calculated by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. Skip to content Chapter 7. Cost and Industry Structure. Learning Objectives By the end of this section, you will be able to:. Analyze short-run costs as influenced by total cost, fixed cost, variable cost, marginal cost, and average cost.
Calculate average profit Evaluate patterns of costs to determine potential profit. Where do marginal and average costs meet? Why are total cost and average cost not on the same graph? Fill in Table 4 for total cost, average variable cost, average total cost, and marginal cost.
However, the cost structure of all firms can be broken down into some common underlying patterns. When a firm looks at its total costs of production in the short run, a useful starting point is to divide total costs into two categories: fixed costs that cannot be changed in the short run and variable costs that can be changed.
The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of Table 1 should look familiar — they come from the Clip Joint example we saw earlier — but there are also three new columns showing average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit rather than a total basis.
Watch this clip as a continuation from the video on the previous page to see how average variable cost, average fixed costs, and average total costs are calculated. Average total cost is total cost divided by the quantity of output. Average cost curves are typically U-shaped, as Figure 1 shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost; mathematically, the denominator is so small that average total cost is large.
Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced.
But as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns kick in. Figure 1.
Cost Curves at the Clip Joint. The information on total costs, fixed cost, and variable cost can also be presented on a per-unit basis. Average total cost ATC is calculated by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped.
Average variable cost AVC is calculated by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is typically U-shaped or upward-sloping. Marginal cost MC is calculated by taking the change in total cost between two levels of output and dividing by the change in output.
The marginal cost curve is upward-sloping. Average variable cost obtained when variable cost is divided by quantity of output. The total cost TC curve is found by adding total fixed and total variable costs. Its position reflects the amount of fixed costs, and its gradient reflects variable costs. Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by an increasing output, average fixed costs will continue to fall.
The average variable cost AVC curve will at first slope down from left to right, then reach a minimum point, and rise again. Average total cost ATC is also called average cost or unit cost. Average total costs are a key cost in the theory of the firm because they indicate how efficiently scarce resources are being used.
Average variable costs are found by dividing total fixed variable costs by output. Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in total cost when output is increased by one unit. It is important to note that marginal cost is derived solely from variable costs, and not fixed costs.
The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are subject to the principle of variable proportions. Average total cost and marginal cost are connected because they are derived from the same basic numerical cost data. The general rules governing the relationship are:.
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