ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 19 55 Firm Costs Krugman Wells The various types of costs a firm faces including fixed cost variable cost and total cost How a firm s costs generate marginal cost curves and average cost curves 3 of 23 From the Production Function to Cost Curves A fixed cost is a cost that does not depend on the quantity of output produced A fixed cost is the cost of the fixed input A variable cost is a cost that depends on the quantity of output produced A variable cost is the cost of the variable input 4 of 23 Total Cost Curve The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output TC FC VC The total cost curve becomes steeper as more output is produced due to diminishing returns 5 of 23 Total Cost Curve for George and Martha s Farm Cost Total cost TC 2 000 I 1 800 H 1 600 G 1 400 F 1 200 E 1 000 D 800 C 600 400 200 B A 0 19 Point on graph A B C D E F G H I 36 51 Quantity of Quantity of wheat Q labor L worker bushels 0 1 2 3 4 5 6 7 8 0 19 36 51 64 75 84 91 96 64 75 Variable cost VC O 200 400 600 800 1 000 1 200 1 400 1 600 84 91 96 Quantity of wheat bushels Fixed Cost FC Total cost TC FC VC 400 400 400 400 400 400 400 400 400 400 600 800 1 000 1 200 1 400 1 600 1 800 2 000 6 of 23 Two Key Concepts Marginal Cost and Average Cost 7 of 23 Costs at Selena s Gourmet Salsas 8 of 23 Total Cost and Marginal Cost Curves for Selena s Gourmet Salsas a Total Cost b Marginal Cost Cost Cost of case 8th case of salsa increases total cost by 180 1 400 T C 250 MC 1 200 200 2nd case of salsa increases total cost by 36 1 000 800 150 600 100 400 50 200 0 1 2 3 4 5 6 7 8 9 10 Quantity of salsa cases 0 1 2 3 4 5 6 7 8 9 10 Quantity of salsa cases 9 of 23 Why is the Marginal Cost Curve Upward Sloping Because there are diminishing returns to inputs in this example As output increases the marginal product of the variable input declines This implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises And since each unit of the variable input must be paid for the cost per additional unit of output also rises 10 of 23 Average Cost Average total cost often referred to simply as average cost is total cost divided by quantity of output produced ATC TC Q Total Cost Quantity of Output A U shaped average total cost curve falls at low levels of output then rises at higher levels Average fixed cost is the fixed cost per unit of output AFC FC Q Fixed Cost Quantity of Output 11 of 23 Average Cost Average variable cost is the variable cost per unit of output AVC VC Q Variable Cost Quantity of Output 12 of 23 Average Total Cost Curve Increasing output has two opposing effects on average total cost The spreading effect the larger the output the greater the quantity of output over which fixed cost is spread leading to lower the average fixed cost The diminishing returns effect the larger the output the greater the amount of variable input required to produce additional units leading to higher average variable cost 13 of 23 Average Costs for Selena s Gourmet Salsas 14 of 23 Average Total Cost Curve for Selena s Gourmet Salsas Cost of case Average total cost ATC 140 Minimum average total cost 120 100 M 80 60 40 20 0 1 2 3 4 Minimum cost output 5 6 7 8 9 10 Quantity of salsa cases 15 of 23 Two Key Concepts Marginal Cost and Average Cost Marginal cost is upward sloping due to diminishing returns Average variable cost also is upward sloping but is flatter than the marginal cost curve Average fixed cost is downward sloping because of the spreading effect The marginal cost curve intersects the average total cost curve from below crossing it at its lowest point This last feature is our next subject of study 16 of 23 Marginal Cost and Average Cost Curves for Selena s Gourmet Salsas Cost of case 250 The bottom of the U curve is at the level of output at which the marginal cost curve crosses the average total cost curve from below MC Is this an accident No 200 150 ATC AVC 100 M 50 AFC 0 1 2 3 4 5 6 7 8 9 10 Quantity of salsa cases Minimum cost output 17 of 23 Minimum Average Total Cost The minimum cost output is the quantity of output at which average total cost is lowest the bottom of the U shaped average total cost curve At the minimum cost output average total cost is equal to marginal cost At output less than the minimum cost output marginal cost is less than average total cost and average total cost is falling And at output greater than the minimum cost output marginal cost is greater than average total cost and average total cost is rising 18 of 23 The Relationship Between the Average Total Cost and the Marginal Cost Curves Cost of unit If marginal cost is above average total cost average total cost is rising MC MC ATC H B A 1 A MC L M 2 B 2 1 If marginal cost is below average total cost average total cost is falling Quantity 19 of 23 Does the Marginal Cost Curve Always Slope Upward In practice marginal cost curves often slope downward as a firm increases its production from zero up to some low level This initial downward slope occurs because a firm that employs only a few workers often cannot reap the benefits of specialization of labor This specialization can lead to increasing returns at first and so to a downward sloping marginal cost curve Once there are enough workers to permit specialization however diminishing returns set in 20 of 23 More Realistic Cost Curves Cost of unit 2 but diminishing returns set in once the benefits from specialization are exhausted and marginal cost rises MC ATC A VC 1 Increasing specialization leads to lower marginal cost Quantity 21 of 23 1 Total cost is equal to the sum of fixed cost which does not depend on output and variable cost which does depend on output 2 Average total cost total cost divided by quantity of output is the cost of the average unit of output and marginal cost is the cost of one more …