Costs: Some additional notes

1. Costs: Some additional notes Econ 2020

2. Average Total Cost Average Total Cost is found by dividing Total Cost by output. Average Total Cost (ATC or AC) is how much it costs, on average, to make one unit of output.

3. Marginal Cost Marginal Cost is the extra or additional cost associated with making one more unit of output. TC  VC MC = -------------- = ------------  Y  Y

4. Illustration Output TC AC MC 0 55 --- -- 1 85 85 30 2 110 55 25 3 130 43.33 20 4 160 40 30 5 210 42 50

5. AFC and AVC Average Total Cost can be divided into Average Fixed Cost (AFC) and Average Variable Cost (AVC).

6. Total Cost Curve Cost $ Total cost Variable costs Fixed costs Output (y)

7. Average and Marginal Cost The orange line is AVC, the purple line is AC (average total cost), the blue line is marginal cost. MC AC AVC Output (y)

8. Things to Notice • The difference between AC and AVC is AFC. • Marginal cost intersects AVC at its minimum point. • Marginal cost intersects AC at its minimum point. • AFC decreases as output increases.

9. MARGINAL AND TOTAL COST Marginal cost is the slope of the total cost curve.

10. AVC and AFC • AFC is FC divided by output • AVC is VC divided by output • AFC always decreases as output increases. • AVC will often decrease at first, and then increase.

11. Relationship of AC and MC • When MC < AC, AC is decreasing because MC “pulls it down.” • When MC>AC, AC is increasing because MC “pulls it up.”

12. An Example using Grades Let AG be your cumulative grade point average (GPA). Let MG be your grade point for fall of 2000. If your GPA is now 2.5 and you earn a 3.0 this semester, your GPA will rise. If your GPA is now 2.5 and you earn a 2.0 this semester, your GPA will fall. If MG is higher than AG, your AG will rise. If MG is lower than AG, your AG will fall.

13. Factors Affecting Cost • Prices of inputs • The production function

14. Cost Schedule If we know the prices of input and the production function, we can calculate the firm’s cost schedule.

15. Marginal Product And Marginal Cost Marginal Product (MP) is the change in total product divided by the change in input. It tells you how much extra product each unit of extra input makes. When MP is increasing, MC is falling because each added input is more productive than the last.

16. MP And MC When MP is decreasing, MC is rising because each added input is less productive than the last.

17. Shape of Cost Curves In the short run, AVC and AC are U-shaped because the variable factors tend to show an initial phase of increasing returns, followed by decreasing (diminishing) returns.

18. Least-Cost Rule If a firm uses two or more variable inputs to produce a given amount of output, it will select the combination of inputs that will minimize cost for a given level of output.

19. How the Rule Works To produce a given level of output, a firm should buy inputs until it has equalized the marginal product per dollar spent on each input. Marginal Product of X1 Marginal Product of X2 Price of X1 Price of X2 where X1 and X2 are two different variable inputs. ------------------------- = ------------------------

20. Least Cost Rule • Working the least-cost rule is similar to finding consumer optimum under a budget constraint. • We find the ratio of Marginal Product to price for each input. If the firm is producing at minimum cost, these ratios are equal. • If the ratios are not equal, the firm should use more of the input with the higher ratio and less of the input with the lower ratio.

21. Example • MP of input 1 is 20 and its price is $10. So the ratio is 2. • The price of input 2 is $15. If the firm is producing the least-cost combination, then the MP of input 2 must be 30 because 30/15 = 2.

22. Another example • The MP of input 1 is 60 and its price is $5. The MP of input 2 is 80 and its price is $10. • Is the firm operating at the least-cost point? • No. The firm could lower costs of producing the same amount of output by using more of input 1 (ratio is 12) and less of input 2 (ratio is 8).

23. Substitution Rule If the price of one factor falls while all other factor prices remain the same, firms will profit by substituting the now cheaper factor for the all the other factors.

24. Profit = Total Revenue -- Total Expenses

25. Types of Expenses Cash expenses -- money spent for materials, labor, utilities, rent, interest, insurance, property taxes, and other miscellaneous items. Some cash expenses are fixed, some are variable.

26. Depreciation Depreciation is a non-cash business expenses. Depreciation measures the decline in a durable asset’s value, caused by use, age, or obsolescence. Depreciation spreads the cost of a durable asset over the asset’s years of service.

27. Income Taxes Income taxes are not classified as an expense. Why not? Income taxes are paid on profits. Expenses are subtracted before profits are figured.

28. Opportunity Costs An opportunity cost is revenue (or benefit) foregone by making one choice instead of another. For example, a farmer might choose to use land to produce cotton. The opportunity cost would be the revenue given up from not growing other crops. There is always an opportunity cost, even if the farmer has made the most profitable decision possible.

29. Opportunity Costs Outside Markets Opportunity costs also apply to decisions outside markets. The allocation of student time can be explained using opportunity costs. For example, students spend less time watching TV the night before an exam than other nights. Time has a high opportunity cost before a test.