Microeconomics: Variable Cost

Only available on StudyMode
  • Download(s) : 67
  • Published : April 29, 2011
Open Document
Text Preview
Microeconomics Topic 6: “Be able to explain and calculate average and marginal cost to make production decisions.” Reference: Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 13. Long-Run versus Short-Run In order to understand average cost and marginal cost, it is first necessary to understand the distinction between the “long run” and the “short run.” Short run: a period of time during which one or more of a firm’s inputs cannot be changed. Long run: a period of time during which all inputs can be changed. For example, consider the case of Bob’s Bakery. Bob’s uses two inputs to make loaves of bread: labor (bakers) and capital (ovens). (This is obviously a simplification, because the bakery uses other inputs such as flour and floor space. But we will pretend there are just two inputs to make the example easier to understand.) Bakers can be hired or fired on very short notice. But new ovens take 3 months to install. Thus, the short run for Bob’s Bakery is any period less than 3 months, while the long run is any period longer than 3 months. The concepts of long run and short run are closely related to the concepts of fixed inputs and variable inputs. Fixed input: an input whose quantity remains constant during the time period in question. Variable input: an input whose quantity can be altered during the time period in question. In the case of Bob’s Bakery, ovens are a fixed input during any period less than 3 months, whereas labor is a variable input. Fixed Cost, Variable Cost, and Total Cost In the short run, a firm will have both fixed inputs and variable inputs. These correspond to two types of cost: fixed cost and variable cost. Fixed cost (FC): the cost of all fixed inputs in a production process. Another way of saying this: production costs that do not change with the quantity of output produced.

Variable cost (VC): the cost of all variable inputs in a production process. Another way of saying this: production costs that change with the quantity of output produced. In the case of Bob’s Bakery, the cost of renting ovens is a fixed cost in the short run, while the cost of hiring labor is a variable cost. Since fixed inputs cannot be changed in the short run, fixed cost cannot be changed either. That means fixed cost is constant, no matter what quantity the firm chooses to produce in the short run. Variable cost, on the other hand, does depend on the quantity the firm produces. Variable cost rises when quantity rises, and it falls when quantity falls. When you add fixed and variable costs together, you get total cost. Total cost (TC): the total cost of producing a given amount of output. TC = FC + VC Note: the total cost curve has the same shape as the variable cost curve because total costs rise as output increases. In the case of Bob’s Bakery, suppose the firm’s rental payments on ovens add up to $40 a day; then FC = 40. And suppose that if the firm produces 100 loaves in a day, its labor cost (wages for bakers) is $500; then VC = 500. The firm’s total cost is TC = 40 + 500 = 540. Suppose that when the firm produces 150 loaves a day, its labor cost rises to $700; then the new VC = 700 and the new TC = 40 + 700 = 740. This information is summarized in the table below. Bob’s Bakery’s Total, Fixed, and Variable Costs Quantity Total Cost Fixed Cost Variable Cost (per day) 100 540 40 500 150 740 40 700 Average Cost or Average Total Cost Average cost (AC), also known as average total cost (ATC), is the average cost per unit of output. To find it, divide the total cost (TC) by the quantity the firm is producing (Q). Average cost (AC) or average total cost (ATC): the per-unit cost of output. ATC = TC/Q

Since we already know that TC has two components, fixed cost and variable cost, that means ATC has two components as well: average fixed cost (AFC) and average variable cost (AVC). The AFC is the fixed cost per unit of output, and AVC is the variable cost per unit of output. ATC = AFC + AVC AFC = FC/Q...
tracking img