Production and Costs
Total Costs
Putting the Cost Curves Together
Page 1 of 2
We’re going to put everything together now as we wrap up our lectures on the cost curves. Again, a lot of students have to
kind of fight the idea of cost curves because it just looks like a bunch of lines floating around on a page. Things are going
to go better for you in your Economics class if instead of just seeing lines on a page, you have some sense of the intuition
of the story behind them. And that’s what we tried to do in these last few lessons. I’m going to wrap everything up now
and draw the picture that we’re going to take with us into the lectures on profit maximization. And as I wrap up, I hope I’ll
be reinforcing some of the intuition that we’ve covered in the previous lectures.
So let’s look now at two curves that we were drawing in the last segment—the average variable cost curve and the
average total cost curve. Now, what should you think about when you see these two curves? Well, let’s look at average
variable cost first. Remember, the average variable cost curve is the mirror image of the average product curve. As
workers become more productive, it takes fewer workers to produce a television set, and the cost of producing a television
set, the labor cost, begins to fall. When the workers’ average productivity begins to fall, the labor cost per television goes
back up.
So when you look at the average variable cost curve, you’re getting a summary of the productivity, the average
productivity, of the workers of the firm. We are experiencing here increasing average product, down to this point of
minimum average variable cost, then the average product of a worker starts to fall and the labor cost per unit goes back
up. That’s what you’re thinking about when you’re looking at that curve.
The average total cost curve is just the sum of average variable cost and average fixed cost. I want to take a little break
here to remind you about where these numbers come from. Remember, we have the average fixed cost, which is the
fixed cost per unit of output, and we also have the average variable cost, which is the variable cost per unit of output. This
is the labor cost. And if you add the labor cost on to the cost of the other inputs, then you’re going to get the average total
cost, the total cost per unit of output. Labor cost added to the cost of all of the fixed inputs gives you the average total
cost.
And notice that average total cost is falling at first, but eventually starts back up again. It’s falling at first for two reasons. It
falls at first—I’m going to put these numbers next door so we can talk about them. It falls at first because you’re able to
spread your fixed costs out thinner and thinner and thinner over your increasing output. It also falls at first because
increasing productivity means it takes fewer workers, on average, to produce a television set. After a certain point,
however, even though the average fixed cost continues to fall, even though you’re spreading your overhead out thinner
and thinner, we’re now working against decreasing labor productivity. After a while, your workers start to get less
productive on average, and that then tends to raise the average costs up. So we’ve got these two forces in balance. Your
overhead is spreading thinner and the average fixed cost is falling, but your workers are getting less productive, so the
average variable cost is rising. Eventually, the effect of the average variable cost takes over and begins to pull the
average total cost up. But the minimum point of average total cost will be further out. That is, it will be further out than the
average variable cost minimum, because even after you’ve reached the maximum of labor productivity, you still have
some more of that overhead spreading to keep pushing your average costs down for just a little bit longer. Then the falling
labor productivity takes over and starts to pull up the average total cost.
The thing to notice about these two curves is that the difference between them, the difference between the average total
cost and the average variable cost, at every point, is the average fixed cost. Here, the average fixed cost is a big gap.
Here, the average fixed cost is smaller, and that gap shrinks and shrinks and shrinks and shrinks. As these curves move
out, as we increase the production of television sets, the average total cost curve and the average variable cost curve get
closer and closer and closer together. Why is that? Why do these curves get closer and closer together as we move
further out, as we increase our output? These curves get closer together because the vertical distance between them at
any point is simply the average fixed cost. And since the average fixed cost is always shrinking as output increases, these
curves get closer and closer together. They never quite touch, but they will approach each other asymptotically.
All right, so there’s the average total cost curve, which is the average variable cost curve added on to that average fixed
cost curve. And there’s one more curve we need to draw, and that is the marginal cost curve. Now, how do we draw the
Production and Costs
Total Costs
Putting the Cost Curves Together
Page 2 of 2
marginal cost curve in this picture with no other points of reference? We draw it by remembering the relationship between
averages and marginals. When the marginal is below the average, it’s pulling it down. When the marginal is above the
average, it’s pulling it up. That means that every marginal cost curve will cut through average cost curves at their
minimum point. Because when the curve is below it, the curves continue to fall. When the marginal cost curve rises above
it, it pulls the average up. So we know that the marginal cost curve will look like this.
Remember, the marginal cost curve tells you about the marginal product of labor. It tells you about the workers that you
have to hire—the additional workers that you have to hire to produce an extra television set. Here, the marginal product of
labor is increasing due to teamwork and specialization. The marginal product of labor reaches its maximum when the
marginal cost is at a minimum. Remember, marginal product and marginal cost are reciprocally related. Then the marginal
cost curve cuts through the average variable cost curve at the minimum of average variable cost. Over here it’s pulling the
average down, and once it crosses it, it begins to pull the average up. The same with the average total cost curve. As long
as the marginal is above the average total, it’s pulling the average total cost down. But when the marginal cost curve cuts
through it, it starts to pull it up.
With these three curves we are ready to go into a discussion of how the firm can maximize its profits. These three curves
become very important in describing the profit-maximizing choice of a firm. Anytime you look at these curves what you’re
really looking at is information about the firm’s productivity and the price the firm has to pay for its inputs. That’s the
information that’s summarized in these curves. Now we’ll take that information and use it to predict profits. But before I
end this lecture, let me ask you one more question. If you were a firm that wanted to maximize its profits, which level of
output would you choose for your firm in the short run? Which level of output in the short run would you choose? Would
you choose that level of output that maximized marginal product, that is, where teamwork and specialization were at a
peak? Would you choose that level of output that minimizes marginal cost? That’s your first choice. Or perhaps you’d
choose that level of output that’s at the bottom of the average variable cost curve, where the labor cost per unit is at a
minimum? Would you choose that point? That’s the point where the average product of labor has reached its peak, where
you’re getting the most output per worker possible. Is that the point you’d choose? Or finally, you might choose to produce
at the point where average total cost is at a minimum. This is where the total cost of producing a television, on average, is
the lowest it’s going to get, where the combined labor and fixed input costs per television are the lowest they’ll ever be.
Which point would you choose? Minimum average total cost, minimum average variable cost, or minimum marginal cost.
Which one is best?
The answer is, none of the three. You don’t have enough information in this picture to answer the question, what is the
profit maximizing choice for a firm. You know why? Because the only information that’s in this picture is information about
costs, and costs is only one side of the story. What’s the other side of the story? If you want to maximize profit, what else
do you need to be concerned about besides your costs? The answer is, you also have to be concerned about revenue.
The revenue that you earn from selling television sets. See, there’s no information in this picture at all about the price of a
television set. And until you know what the price of a television set is, you don’t know how many televisions you want to
produce. If the price is high enough, you’d be willing to incur very high costs. You cannot tell from looking at this diagram
alone what the profit maximizing choice is. This diagram tells you only about costs. That is, it summarizes the firm’s
technology and the price of the firm’s inputs to give you information about the cost of producing televisions.
Now I’ll reel out information about revenue in the next lectures to begin to discern the profit-maximizing choice of a firm.