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4. Describe the various trajectories of different cost concepts. Include AFC, AVC, AC, MC

and TC.

TOTAL COST CURVES:

The total cost of producing a good can be represented by three related curves, total cost curve, total

variable cost curve, and total fixed cost curve. The total cost curve is the vertical summation of the

total variable cost curve and the total fixed cost curve.

Total Fixed Cost Curve: The total fixed cost (TFC) curve is a horizontal line.

Total fixed cost is equal to $3 and does not change with the quantity of output produced, thus the

TFC curve is a flat, horizontal line.

Total Variable Cost Curve: The total variable cost (TVC) curve is a positively-sloped line that reflects

increasing then decreasingmarginal returns

The TVC curve emerges from the origin with a relatively steep slope, flattens, then becomes

increasingly steeper.

The TVC for one article is $5, this then rises to $8 for two etc., finally reaching $43 for ten

Note:

From Quantity 0-3, there is Economies Of scale From Quantity 8-10, there is Diseconomies of Scale

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.

Total Cost Curve: The total cost (TC) curve can be derived as the vertical summation of the TVCand TFC curves. In other words, the TC curve can be found by shifting the TVC vertically by the

amount of TFC. This means that the shape of the TC curve is identical to that of the TVC. The twocurves have identical slopes for each quantity of output.

Here vertical difference between the TC and TVC curves is exactly $3.00, the value of TFC.

All three curves together:

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An important conclusion from this derivation of the TC curve is that the vertical distance between TC

and TVC curves is the same at ALL output quantities. The reason, of course, is that this vertical

distance IS total fixed cost. Because total fixed cost is constant, the vertical distance is constant.

This further implies that the slopes of the TC and TVC curves are identical at each and every output

quantity. of total fixed cost. In other words, the TC and TVC curves are essentially the same curve,

the TC curve just happens to be a little bit higher in the diagram, higher by the amount of total fixed

cost.

Thus TC= TFC + TVC

AVERAGE FIXED COST:

Average fixed cost is thetotal fixed costper unit of output

average fixed cost =

total fixed cost

quantity of output

An alternative specification for average fixed cost is found by subtracting average variable cost from

average fixed cost:

average fixed cost = average total cost - average variable cost

The Average Fixed Cost Curve

The key feature of this average fixed cost curve is the shape. The average fixed cost curve is

negatively sloped. Average fixed cost is relatively high at small quantities of output, then declines as

production increases. The more production increases, then the more average fixed cost declines.

The reason behind this perpetual decline is that a given FIXED cost is spread over an increasingly

larger quantity of output.

Note: At any point on the curve Q* C=Constant

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For example: A thousand dollars of fixed cost averages out to $10 per unit if only 100 units are

produced. But if 10,000 units are produced, then the average shrinks to a mere 10 cents per unit.Its Use:

Average fixed cost, when combined with price, indicates whether or not a firm should shut down

production in the short run. If price is greater than average fixed cost, then the firm is able to pay, at

least, fixed cost. Even though it might be incurring an economic loss, it will lose less by producing

than by shutting down production. If, however, price is less than average fixed cost, then the firm is

better off shutting down production.

AVERAGE VARIABLE COST:

Average variable cost is thetotal variable costper unit of output incurred when afirmengages

inshort-run production.

In general, average variable cost decreases with additional production at relatively small quantities

of output, then eventually increases with relatively large quantities of output. This pattern is

illustrated by a U-shaped average variable cost curve.

average variable cost =

total variable cost

quantity of output

An alternative specification for average variable cost is found by subtracting average fixed cost from

average total cost:

average variable cost = average total cost - average fixed cost

The Average Variable Cost Curve

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The relation between average variable cost and the

quantity of production can be represented by a

curve

The key feature of this average variable cost is the

shape. It is U-shaped, meaning it has a negative

slopefor small quantities of output, reaches a

minimum value, then has a positive slope for larger

quantities. This U-shape is indirectly attributable to

thelaw of diminishing marginal returns.

The U-shape of the average variable cost curve is

indirectly caused by increasing, then decreasing

marginal returns (and the law of diminishing

marginal returns). The negatively-sloped portion is

attributable to increasing marginal returns and the

positively-sloped portion is attributable to

decreasing marginal returns (and the law of diminishing marginal returns).

Its Use:

Average variable cost, when combined withprice, indicates whether or not a firm should shut down

production in the short run. If price is greater than average variable cost, then the firm is able to pay

all variable cost and a portion of fixed cost. Even though it might be incurring an economic loss, it

will lose less by producing that by shutting down production. If, however, price is less than average

variable cost, then the firm is better off shutting down production.

AVERAGE TOTAL COST:

Averagetotal costis the total cost per unit of output incurred when afirm engages in short-run

production.

In general, average total cost decreases with additional production at relatively small quantities of

output, then eventually increases with relatively large quantities of output. This pattern is illustrated

by a U-shaped average total cost curve.

Calculating Average Total Cost

The standard method of calculating average total cost is to divide total cost by the quantity,

illustrated by this equation:

average total cost =

total cost

quantity of output

An alternative specification for average total cost is found by summing average variable cost and

average fixed cost:

Average Variable Cost Curve

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average total cost = average variable cost + average fixed cost

The Average Total Cost Curve

The key feature of this average total cost is the

shape. It is U-shaped, meaning it has a negative

slopefor small quantities of output, reaches a

minimum value, then has a positive slope for larger

quantities. This U-shape is indirectly attributable to

thelaw of diminishing marginal returns.

Its Use;

Average total cost, when combined with price,

determines per unitprofit or loss that a profit-

maximizing firm receives from short-run

production. If price is greater than average total

cost, then the firm receives positive economic

profitper unit. If price is less than average total

cost, the firm incurs a loss, or negative economic

profit, per unit. If price is equal to average total

cost, then the firm is just breaking even, receiving neither a per unit profit nor incurring a per unit

loss.

Average Total Cost Curve

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5. Explain the relationship between AC & MC. Connect this to discussion on economies of

scale.

Marginal Cost:

Marginal cost is the change in total cost that arises when the quantity produced changes by one

unit. That is, it is the cost of producing one more unit of a good.

A typical Marginal Cost Curve

AC n MC:

http://en.wikipedia.org/wiki/File:Marginalcost.gifhttp://en.wikipedia.org/wiki/File:Marginalcost.gifhttp://en.wikipedia.org/wiki/File:Marginalcost.gif

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The MC curve will intercept the AC curves at its minimum point. When AC is decreasing, MC lies

below AC - because when MC is below AC, producing an extra unit of output will pull down

average cots When AC is increasing, MC lies above AC - because when MC is above AC,

producing an extra unit of output will raise average costs Therefore MC will intercept the AC

curve at its minimum point

6. Relate LAC and SAC or Connect the plan (SAC) that the firm operates with given the

planning curve (LAC).

Another term for the long-run average cost curve (LRAC). Using the name planning curve

indicates that the long-run average cost curve is used to "making plans" especially

concerning the desired scale of operations of a firm. That is, in the long run a firm will seek

the plant size that maximizes long-run profit by equating long-run marginal cost and

marginal revenue. It will then pick out the appropriate plant size off the long-run average

cost with the minimum short-run average total cost.

PLANNING HORIZON:

Another term for the long-run average cost curve. The long-run average cost curve is termed the

planning horizon or planning curve because it provides information that a firm can use to plan factory

construction and expansion in the long run.

Along-run average costcurve, or planning curve, is displayed in the exhibit below. This

curve has the expected U-shape created byeconomies of scale(orincreasing returns toscale) for small quantities of output anddiseconomies of scale(ordecreasing returns toscale) for large output quantities. Of note is that this long-run average cost curve is an

envelope of several short-run average total cost curves.

Short and Long, Together

Long Run Average Cost

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To see why the long-run average cost curve is

termed a planning curve, a distinction between

the short-run and long-run operation offirmis in order. Short-run operation requires that afirm decide the quantity ofvariable inputs it needs in order to produce a given output, given

one or morefixed input. In other words, Waldo's TexMex Taco World must decide how manyworkers to employ and how much lettuce and sour cream to buy each day. But Waldo is not

really concerned with the size of the restaurant for day-to-day operation. The restaurant isa given.

When Waldo expects limited business on the weekdays, he purchases small quantities of

lettuce and sour cream and schedules only a handful of employees. However, when he

expects to sell more on the weekends, he schedules more employees and purchases more

lettuce and sour cream. In effect, Waldo is using a given short-run average and marginalcost curves such as the ones labeled SRATC(a) and SRMC(a) that can be revealed by

clicking the button labeled [Short Run]. Asdemand(and price) change in the short-run,Waldo adjusts his output quantity based on his marginal cost.

However, even as Waldo makes these day-to-day decisions aboutshort-run production, he

has his eye on the long run. He has plans to buy additionalcapitalequipment, add a fewmore tables and chairs, and expand the size of the restaurant. Even as Waldo schedules the

number of employees to work next Thursday, he is also reviewing architectural plans for the

new construction. Even as he orders extra boxes of lettuce for the weekend, he is making adecision between oak chairs or pine. In essence, a firm operates in both the short run andthe long run simultaneous.

Long Run Adjustment

Waldo's long run plans are intertwined with his day-to-day operation. If a firm determinesthat day-to-day operations are straining the capacity of the fixed input, then it is likely to

move ahead on plans to expand. Waldo, for example, realizes that his restaurant cannot

service all of his potential customers. Every day, a line of customers extends out the doorand circles the block. This is just the sort of thing that induces Waldo to expand hisrestaurant, to move from short run to the long run. In effect, Waldo is deciding if he should

shift his current short-run cost curves from SRATC(a) and SRMC(a), to another set. Clicking

the [Long Run Expansion] button reveals such a new set of curves, SRATC(b) and SRMC(b),associated with reducing the size of his restaurant.

However, if Waldo's restaurant is never more than half filled with day-to-day operations,

then he might decide to remodel his existing place or move to a smaller one. Once again,

Waldo intertwines the short run and the long run. In effect, Waldo is deciding if he should

shift his current short-run cost curves from SRATC(a) and SRMC(a), to another set. Clickingthe [Long Run Reduction] button reveals such a new set of curves, SRATC(c) and SRMC(c),associated with reducing the size of his restaurant.

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The short-run average total cost curve (SATC or SAC)

Typical short run average cost curve

The average total cost curve is constructed to capture the relation between cost per unitand the level ofoutput,ceteris paribus. A productively efficient firm organizes itsfactors of

productionin such a way that theaverage costof production is at lowest point andintersects Marginal Cost. In theshort run, when at least one factor of production is fixed,

this occurs at the optimum capacity where it has enjoyed all the possible benefits ofspecializationand no further opportunities for decreasing costs exist. This is usually not U

shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the

right.Example: Q=2K.5L.5STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)Shortrun average cost equals average fixed costs plus average variable costs. Average fixed cost

continuously falls as production increases. The shape of the average variable cost curve is

directly determined by diminishing marginal returns to the variable input (conventionallylabor).[1]Average variable cost eqauls w/APL or the wage rate divided by the average

product of labor.

The long-run average cost curve (LRAC)

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Typical long run average cost curve

Essentially, the long-run average cost curve depicts what the minimum per-unit cost of

producing a certain number of units would be if all productive inputs could be varied. Given

that LRAC is an average quantity, one must not confuse it with the long-run marginal costcurve, which is the cost of one more unit. The LRAC curve is created as an envelope of an

infinitenumber of short-run average total cost curves. The typical LRAC curve is U-shaped,reflectingeconomies of scalewhen negatively-sloped anddiseconomies of scalewhen

positively sloped. Contrary to Viner, the envelope is not created by the minimum point ofeach short-run average cost curve. This mistake is recognized as Viner's Error.

In a long-runperfectly competitiveenvironment, the equilibrium level of output corresponds

to theminimum efficient scale, marked as Q2 in the diagram. This is due to the zero-profitrequirement of a perfectly competitive equilibrium. This result, which implies production is

at a level corresponding to the lowest possible average cost, does not imply that otherproduction levels are not efficient. All points along the LRAC are productively efficient, bydefinition, but are not equilibrium points in a long-run perfectly competitive environment.

In some industries, the LRAC is always declining (economies of scale exist indefinitely). Thismeans that the largest firm tends to have a cost advantage, and the industry tends

naturally to become a monopoly, and hence is called anatural monopoly. Naturalmonopolies tend to exist in industries with high capital costs in relation to variable costs,such aswater supplyandelectricity supply.

The average cost is the total cost divided by the number of units produced.

The marginal cost curve (MC)

Typical marginal cost curve

Amarginal costthat graphically represents the relation between marginal cost incurred by a

firm in the short-run product of a good or service and the quantity of output produced. This

curve is constructed to capture the relation between marginal cost and the level of output,holding other variables, like technology and resource prices, constant. The marginal costcurve is U-shaped. Marginal cost is relatively high at small quantities of output, then as

production increases, declines, reaches a minimum value, then rises. The marginal cost is

shown in relation to marginal revenue, the incremental amount of sales that an additional

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product or service will bring to the firm. This shape of the marginal cost curve is directly

attributable to increasing, then decreasing marginal returns (and the law of diminishing

marginal returns -Diminishing returns). Marginal cost equal w/MPL. For most productionprocesses the marginal product of labor initially rises, reaches a maximum value and then

continuously falls as production increases. Thus marginal cost initially falls, reaches aminimum value and then increases.[2]

Combining cost curves

Cost curves inperfect competitioncompared to marginal revenue

Cost curves can be combined to provide information about firms. In this diagram for

example, firms are assumed to be in aperfectly competitivemarket. The marginal cost

curve will cut the average cost curve at its lowest point. In a perfectly competitive market a

firm's profit maximising price would be at or above the price at which the average costcurve cuts the marginal cost curve. If the marginal revenue is above the average total cost

price the firm is deriving an economic profit.

Cost curves and production functions

Assuming that factor prices are constant, the production function determines all costfunctions.[3]The variable cost curve is the inverted short run production function or total

product curve and its behavior and properties are determined by the production function.[4]

Because the production function determines the variable cost function it necessarilydetermines the shape and properties of marginal cost curve and the average cost functions

Productivity and costs in the longrun

In the long run both capital and labour are variable Firms can change the amount of machines or office space that they use Therefore, the law of diminishing returns does not determine the productivity of a

firm in the long run In the long run productivity and costs are driven by returns to scale

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When a firm substitutes labour with machinery, and the investment makes the firm moreefficient, then the average cost curve would move down to the right as in the previous slide.

If investment does not increase productivity and does not change average costs then thecost curve does not change.

Long run average cost curve

The long run average cost curve is simply a collection of short run average cost curves,

illustrating how average costs change as fixed inputs (plant size, type and number ofmachines etc) change. LAC/ Envelope Curve

The LAC is also called the planning curve because it is a guide to the entrepreneur forplanning the future expansion of the firm and choosing the optimal scale or plant size forthe production.

Returns to scale

Returns to scale measures the change in output for a given change in inputs Increasing returns to scale exist when output grows at a faster rate than inputs Decreasing returns exist when inputs grow at a faster rate than outputs Constant returns to scale exist when inputs and outputs grow at the same rate

Costs in the Long Run

All inputs that are under the firms control can be varied there are no fixed costs (all inputs are flexible) Long run is best thought of as a planning horizon irms plan for the long run, but they produce in the short run

Long-Run Planning Curve

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Firms Long-Run Planning Curve

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Alternate answer to Q6:

To study the shape of the AC curve, we have to consider both- the SRAC and LRAC.

Given any point on avg cost curve, the corresponding x-axis value tells you the quantity output,

and corresponding y-axis value tells you the avg cost ie cost/unit for producing that output.

Multiplying both you get the Total cost.

SRAC-

1. The short-run cost curves are normally based on a production function with one variablefactor of production that displays first increasing and then decreasing marginal

productivity. Increasing marginal productivity is associated with the negatively sloped

portion of the marginal cost curve, while decreasing marginal productivity is associated

with the positively sloped portion.

2. The average fixed cost (AFC) curve is the cost of the fixed factor of production divided bythe quantity of units of the output, while the average variable cost (AVC) curve cost

traces out the per unit cost of variable factor of p bnroduction.

3. The U-shaped avqerage total cost (ATC) curve is derived by adding the average fixedand variable costs.

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4. Increasing average costs occur when the effect of declining marginal productivityoverwhelms the effect of spreading the fixed costs.

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LRAC

The long-run cost curves, are also expressed most commonly in their average, or per unit, form,

represented in Figure 2.

The long-run average cost (LRAC) curve is shown to be an envelope of the short-run average

cost (SRAC) curves, lying everywhere below or tangent to the short-run curves.

If there are a discrete number of plant sizes available, the LRAC will be the scalloped curve

obtained by joining those parts of the SRAC curves that represent the lowest cost of production

for a given quantity.