The Theory of the Firm

COSTS, REVENUES AND PROFIT (Part 2)BLINK & DORTON, (2007) p73-94

TYPES OF COSTS

There are three main types of costs:

1. Total Costs (TFC/TVC/TC)2. Average Costs (AFC/AVC/ATC)3. Marginal Cost (MC)

Total, Average and Marginal Costs Per WeekCase Study: Cost of a machine per week $100 (4 machines)

Cost of a worker is $200 per week. Outcome is below:

Total CostsTotal Costs can be further separated into different groups.• Total Fixed Cost (TFC)• Total Variable Cost (TVC)• Total Cost (TC)

Total Fixed Cost (TFC)

• TFC is the total cost of the fixed assets that a firm uses in a given time period.

• Since the number of fixed assets is, by definition, fixed, TFC is a constant amount.

• It is the same whether the firm produces one unit or one hundred units.

• TFC is equal to the number of fixed assets times the cost of each fixed asset.

• In the previous table the TPC is $400 (4 machiens costing $100 each) at every level of output.

Total Variable Cost (TVC)

• Total Variable Costs (TVC) is the variable assets that a firm uses in a given time period.

• TVC increases as the firm uses more of the variable factors.

• TVC is equal to the number of variable factors times the cost of each variable factor..

• Variable Costs are frequently our labour costs.• In the previous example, TVC is $200 when one

worker is being employed and $1200 when six workers are being used.

Total Cost (TC)

• TC is the total cost of all the fixed and variable factors used to produce a certain amount of output.

• It is equal to TFC plus TVC.• In the previous example, the total cost of

producing 105 units of output per week is $1600. It is the fixed cost of $400 plus the variable cost of $1200.

TC

TVC

Output Units

TOTAL COSTS, TOTAL VARIABLE COSTS AND TOTAL FIXED COSTS

TFC

(2) AVERAGE COSTS

There are three main types of average costs:a.Average Fixed Costs (AFC)b.Average Variable Costs (AVC)c. Average Total Costs (ATC)

Average Fixed Cost (AFC)

• Average Fixed Cost (AFC): AFC is the fixed cost per unit of output.

• It is calculated by the equation:AFC = Total Fixed Cost (TFC)

Level of output (q)• As TFC is constant, AFC always falls as output

increases. • In the previous example, AFC is $40 per unit when

output is 10 units and falls to $3.33 per unit when output increases to 120 units.

Average Variable Cost (AVC)

• AVC is the variable cost per unit of output.• It is calculated by the equation:

AVC = Total Variable Cost (TVC) Level of Output (q)

• Average variable cost tends to fall as output increases, and then to start to rise again as output continues to increase.

• This is explained by the hypothesis of eventually diminishing average returns.

Average Variable Cost (AVC)

Why is their diminishing average returns with AVC?• As more of the variable factors are applied to the

fixed factors, the output per unit of the variable factor eventually falls, and so the cost per unit of output eventually begins to rise.

• In the current example AVC is $20 per unit when output is 10 units, falls to $11.11 per unit when output rises to 90 units and then increases to $13.33 when output continues to rise to 120 units.

Average Total Cost (ATC)

• ATC is the total cost per unit of output.• It is equal to AFC plus AVC. • It is calculated by the equation:

ATC = Total Cost (TC) Level of Output (q) • As with AVC, ATC tends to fall as output

increases and then to start to rise again as the output continues to rise.

(3) MARGINAL COST (MC)

Marginal Cost (MC) is the increase in the total Cost of producing an extra unit of output. It is calculated by the equation:

MC = The change in the total cost_ _ _ TC The change in the level of output q

MARGINAL COST (MC)

• MC tends to fall as output increases and then to start to rise again as the output increases.

• This is explained by the hypothesis of eventually diminishing returns.

The Relationship between ATC, AVC, and MC Curves

The MC curve cuts the AVC and the ATC curves at their lower points. This is a mathematical relationship. AFC falls as output increases and, since it is the difference between ATC and AVC, the vertical gap between ATC and AVC gets smaller as output grows.

When economists draw costs curves to illustrate a general position, they draw then very similar to the above diagram.

THE LONG RUN

Definition• The long run is that period of time in which all

factors of production are variable, but the state of technology is still fixed.

• All planning takes place in the long run.• The long run is the planning stage • When planning in the long run, an entrepreneur is

free to adjust the quantity of factors of production that are used and is only restrained by the current level of technology.

THE LONG RUN

• In the long run we look at what happens to costs when all of the factors of production are increased in order to increase output.

The Long Run Average Cost Curve (LRAC)

In theory the long-run average cost curve (LRAC) is an “envelope” curve”. It envelops an infinite number of short run-average cost curves (SRAC).This relationship is shown opposite.

Analysis of the LRAC Curve

• Assume the firm is producing an output of q1

at a cost of per unit of c3. They are operating on the short-run average cost curve SRAC1.

Analysis of the LRAC Curve

An Increase in Demand• Let us assume that the firm now wishes to produce at q2. It

can do so in the short run by simply employing more variable factors and moving along the SRAC1 until q2 is being produced at a cost per unit of C*

• This is a lower cost per unit than before, but the firm will know that they could produce this output even more cheaply if they were able to alter all of their factors of production. (In the long run).

• They will plan ahead to change all of the factors and will eventually move to SRAC2.

Analysis of the LRAC Curve

Producing at SRAC2

• The firm will be producing at an output of q2 at a cost per unit of C2.

• C2 is the lowest possible cost of producing the desired output, q2. It is again a point on the SRAC curve that is tangential to the LRAC curve.

• This single point of on SRAC2 is another single point on the LRAC curve.

Analysis of the LRAC Curve

• The whole LRAC curve is made up of an infinite number of single points from SRAC curves. These curves would represent all of the possible combinations of fixed and variable factors that could be used to produce different levels of output for this firm.

• The LRAC is the boundary between unit cost levels that are attainable by the firm and unit costs levels that are unattainable.

• If possible, the firm would wish to produce different output levels at points on the LRAC curve in order to minimise their cost per unit of output. This may not be possible in the short run.

LRAC & Increasing Returns to Scale

• When the long run costs are falling as output increases, the firm is experiencing increasing returns to scale.

• This means that a given percentage increase in all factors of production will lead to a greater percentage increase in output, thus reducing long run average costs.

LRAC & Constant Returns to Scale

• When long-run unit costs are constant as output increases, the firm is experiencing constant returns to scale.

• This means that a given percentage increase in all factors of production will lead to the same percentage increase in output, thus leaving long-run average costs the same.

LRAC & Decreasing Returns to Scale

• When long run average costs are rising as output increases, the firm is experiencing decreasing returns to scale.

• This means that a given percentage increase in all factors of production will lead to a smaller percentage increase in output, thus increasing long-run average costs.