Chapter 7 Analysis of Costs
Costs affect input choices, investment decisions, and even the decision of whether to stay in business.
A. Economics analysis of costs
1. Total cost: fixed and variable
(1) Total cost represents the lowest total dollar expense needed to produce each level of output q. TC rises as q rises.
(2) Fixed cost represents the total dollar expense that is paid out even when no output is produced. FC is unaffected by any variation in the quantity of output.
(3) Variable cost represents expenses that vary with the level of output and includes all costs that are not fixed.
2. Definition of marginal cost
The marginal cost of production is the additional cost incurred in producing 1 extra unit of output.
For most production activities, in the short run, marginal cost curves are U-shaped.
3. Average cost
(1) Average or unit cost
Average cost is the total cost divided by the total number of units produced.
(2) Average fixed and variable cost
Average fixed cost (AFC) =FC/q, steadily falling.
Average variable cost (AVC) =VC/q.
(3) Minimum average cost
When marginal cost is below average cost, it is pulling average cost down.
When MC is above AC, it is pulling AC up.
When MC just equals AC, AC is neither rising nor falling and it is at its minimum. At the bottom of a U-shaped AC, MC=AC=minimum AC.
4. The link between production and cost
Inputs and production function determine a firm’s cost curve.
(1) Diminishing returns and U-shaped cost curves
In the short run, variable factors tend to show an initial phase of increasing marginal product followed by diminishing marginal product.
The corresponding cost curves show an initial phase of declining marginal costs, followed by increasing MC after diminishing returns have set in.
5. Choice of inputs by the firm
(1) Marginal products and the least-cost rule
To produce a given level of output at least cost, a firm should buy inputs until it has