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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 asAVC (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.
Q AFC
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.)###
100
0
240 24,000 ÷ 100 = $240 per unit
200 120 24,000 ÷ 200 = $120 per unit
300 80 24,000 ÷ 300 = $80 per unit
400 60 24,000 ÷ 400 = $60 per unit
500 48 24,000 ÷ 500 = $48 per unit
600 40 24,000 ÷ 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.
Q AFC
100
0
240
200 120
300 80
400 60
500 48
600 40
OK, we can’t graph this one! Average Fixed Cost
0
20
40
60
80
100
120
140
160
180
200
220
240
260
0 100 200 300 400 500 600 700
Q
$/Q
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 axesNote the same labels as we used before.
Draw the curve
Label the curve
Learn to draw this picture!
Include all the labels every time.
v60
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
v60
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