Cost
Chapter 20
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
Define and analyze fixed costs, variable costs, and total
cost.
Discuss and measure marginal cost.
Distinguish between the short run and the long run.
Define and calculate average fixed, variable, and total
cost.
Graph and analyze the AFC, AVC, ATC, and MC curves.
Analyze the production function and its relationship to the
law of diminishing returns.
List the factors contributing to economies and
diseconomies of scale.
Explain the difference between the shut-down and go-outof-business decisions.
20-2
Costs
Sales – Costs = Profit
or
Total Revenue - Total Cost = Profit
or
–
Total Revenue (TR)
Total Cost (TC)
Profit (the bottom line)
20-3
Fixed Costs (FC)

Fixed costs stay the same no matter how much output
changes.
•
•
•
•
Examples: rent, insurance, salaries, property taxes, and
interest payments.
Even when a firm’s output is zero, it incurs the same fixed
cost.
Sometimes called “sunk cost” because once you have
obligated yourself to pay them, that money has been sunk into
your firm.
The trick is to spread these (fixed) costs over as much output
as possible.
 In other words, to spread your overhead over a large
output.
20-4
Variable Costs (VC)

Variable costs vary with output.
•
•
•
•
As output goes up, VC goes up.
As output goes down, VC goes down.
Examples: wages, fuel, raw materials, electricity, and shipping.
Sometimes a cost may be part fixed and part variable.
 The electricity used by production is a variable cost
because it will go up or down with production.
 Even if your output fell to zero, you would still have to pay
something on your electric bill.
20-5
Total Cost (TC)

Total cost is the sum of fixed and variable costs.
TC = FC + VC
20-6
Hypothetical Cost Schedule
Let’s first try graphing these 3 costs curves.
20-7
Hypothetical Cost Schedule (continued)
FC + VC = TC
20-8
Marginal Cost (MC)
 MC is the cost of producing one additional unit of output.
 MC = change in TC ÷ change in Q
Output
FC
0
$500
VC
$
TC
MC
0
$500
$
-
1
200
700
200
2
300
800
100
3
450
950
150
4
650
1,150
200
5
950
1,450
300
6
1,500
2,000
550
20-9
Marginal Cost (MC)
 MC is the cost of producing one additional unit of output.
At an output of
zero, VC is
always zero
Output
FC
0
$500
VC
MC
0
$500
$ -
200
700
200
300
800
100
450
950
150
4
650
1,150
200
5
950
1,450
300
6
1,500
2,000
550
1
2
3
At an output of
zero, FC is
equal to TC
$
TC
20-10
The Short Run (SR)

As long as there are any fixed costs, we are in the
short run.
•

The present time is always the short run.
The short run is the length of time it takes all fixed
costs to become variable costs.
•
In other words, the length of time it takes to eliminate all fixed
costs.
 A steel firm might need 10 years to pay off such fixed
costs as interest and rent.
 Even a grocery store would need a few weeks or months
to sublet the store and discharge its other obligations.
20-11
The Long Run (LR)

The long run is the time at which all costs become
variable costs.
•
Never exists except in theory…you never rally reach the long
run.
 You will never have a situation in which all your costs are
variable.
 This would mean no rent, no insurance, no guaranteed
salaries, no depreciation, etc.
 As you proceed through the short run, you are forced to
make decisions that will push the long run farther into the
future.
20-12
Another Cost Table: Find TC
Output FC
0
$500
1
500
2
500
3
500
4
500
5
500
6
500
7
500
VC
TC
$0
$500
200
700
300
800
420
920
580 1,080
800 1,300
1200 1,700
1900
AFC
AVC
ATC
MC
2,400
Recall TC = FC + VC
20-13
Average Cost: Now Adding AFC, AVC, and ATC
Output FC
0
$500
1
500
2
500
3
500
4
500
5
500
6
500
7
500
VC
$0
200
300
420
580
800
1200
TC
$500
700
800
920
1,080
1,300
1,700
AFC
$ 500
250
166.7
125
100
83.3
AVC
$200
150
140
145
160
200
ATC
$700
400
306.7
270
260
283.7
1900
2,400
71.4
271.4
342.9
MC
Recall TC = FC + VC
AFC = FC / Output
AVC = VC / Output
ATC = TC / Output
20-14
Average Cost: Finally Adding MC
Output
0
1
2
3
4
5
6
7
FC
$500
500
500
500
500
500
500
500
VC
$0
200
300
420
580
800
1,200
1,900
TC
$500
700
800
920
1,080
1,300
1,700
2,400
AFC
$ 500
250
166.7
125
100
83.3
71.4
AVC
$200
150
140
145
160
200
271.4
ATC
$700
400
306.7
270
260
283.7
342.9
MC
$200
100
120
160
220
400
700
MC is the cost of producing one additional unit of output.
It is best to use the VC column to calculate the MC. If the TC column is
used, you cannot calculate the MC for the first unit of output.
20-15
Graphing the AFC, AVC, ATC & MC curves
Output
0
1
2
3
4
5
6
7
FC
$500
500
500
500
500
500
500
500
VC
$ 0
200
300
420
580
800
1,200
1,900
TC
$500
700
800
920
1,080
1,300
1,700
2,400
AFC
$ 0
500
250
167
125
100
83
71
AVC
$ 0
200
150
140
145
160
200
271
ATC
$ 0
700
400
307
270
260
283
343
MC
$ 0
200
100
120
160
220
400
700
Much of microeconomic analysis involves:
 Filling in a table
 Drawing a graph
 Analyzing the graph
20-16
Graphing the AVC, ATC, and MC curves
Output
FC
0
$500
1
500
2
500
3
500
4
500
5
500
6
500
7
500
VC
$ 0
200
300
420
580
800
1200
1900
TC
$500
700
800
920
1080
1300
1700
2400
AFC
$ 0
500
250
167
125
100
83
71
AVC
$ 0
200
150
140
145
160
200
271
ATC
$ 0
700
400
307
270
260
283
343
MC
$ 0
200
100
120
160
220
400
700
Always do MC first!
AVC and ATC are U-shaped
MC intersects ATC and AVC
at their minimum points.
What is min. AVC?
About $135
What is min. ATC?
About $260
20-17
Further Discussion: You Try Finding
Minimum AVC and ATC points
Minimum AVC: $70
Minimum ATC: $166
20-18
Review
The MC curve intersects the ATC and AVC at their minimum points.
20-19
The Production Function and the Law of
Diminishing Returns



Production function:
relationship between the
maximum amount a firm can
produce and various
quantities of inputs.
Marginal output: the
additional output produced by
the last worker hired.
Law of diminishing returns:
as successive units of a
variable resource (say, labor)
are added to a fixed resource,
beyond some point, the extra
or marginal product
attributable to each additional
unit of the variable resource
will decline.
20-20
Total Output and Marginal Output
20-21
Economies of Scale

Economies of scale: the economies of mass
production, which drive down ATC.
•

In general, we expect large firms to undersell small
firms. Reasons are:
•
•
•

Evidenced by the declining part of the ATC curve
Quantity discounts
Economies of being established
Spreading fixed cost
Economies of scale enable a business to reduce its
cost per unit as output expands.
20-22
Diseconomies of Scale

Diseconomies of scale: the inefficiencies that become
endemic in large firms.
•

In general, at some point, the larger firms get the more
inefficient they become. Reasons are:
•
•

Evidenced by the rising part of the ATC curve
An expanding and growing bureaucracy
A huge and growing corporate authority
Diseconomies of scale increase inefficiencies and also
increase cost per unit.
20-23
A Summing Up

The overlapping forces of increasing returns and
economies of scale drive down ATC.

Eventually, the overlapping forces of diminishing
returns and diseconomies of scale push ATC back up
again.

The U-shaped ATC is very important in economic
analysis and in business strategy.
•
•
•
What size size plant do we build?
How many workers do we hire?
What is the output at which our firm would operate most
efficiently?
20-24
The Decision to Operate or Shut Down:
The Short Run


A firm has 2 options in the short run: operate or shut
down.
When TR > VC, operate.
•
•

If it operates, it will produce the output that will yield the
highest possible profits.
If it is losing money, it will operate at that output at which
losses are minimized.
When TR < VC, shut down.
•
•
•
If the firm shuts down, output is zero.
 Shutting down does not mean zero total costs.
The firm must still meet its fixed costs.
 Remember, at an output of zero, TC = FC.
The firm can not go out of business until all fixed cost
obligations are eliminated.
20-25
Summary Table: Let’s Try 3 Problems
Problem #1: Operate or shut down in the short run?
TC = FC + VC ($5 + $6) = $11
TR = $7
Loss = $4



TR ($7) > VC ($6), so operate to cover FC and then some.
Note: Fixed costs are not relevant in the operate/shut down
decision.
20-26
Summary Table: Let’s Try 3 Problems
Problem #2: Operate or shut down in the short run?
TC = FC + VC ($10 + $9) = $19
TR = $8
Loss = $11



TR ($8) < VC ($9), so shut down
Note: Fixed costs are not relevant in the operate/shut down
decision.
20-27
Summary Table: Let’s Try 3 Problems
Problem #3: Operate or shut down in the short run?
TC = FC + VC ($8 + $12) = $20
TR = $10
Loss = $10



TR ($10) < VC ($12), so shut down
Note: Fixed costs are not relevant in the operate/shut down
decision.
20-28
The Decision to Stay In or Go Out of
Business: The Long Run

In the long run, firms must decide to stay in business
or go out of business.
•
•

The firm will stay in business if the total revenue is greater
than its total cost.
The firm will go out of business if the total cost exceeds total
revenue.
 Going out of business means that all fixed cost
obligations are met.
Does everybody who is losing money go out of
business?
•
•
Eventually (most sooner rather than later).
There are always exceptions to the rule.
20-29
Deriving the Shut-Down and Break-Even Points

The firm can make the same shut-down or operate
decisions on the basis of price and average variable
cost.
Recall, a firm will shut down if VC > TR , or
A firm will shut down if VC > P x Q
Let’s divide both side of the above equation by Output:
VC >
Price x Output
Output
Output
AVC
AVC
> Price
< Price
SHUT DOWN
OPERATE
20-30
Deriving the Shut-Down and Break-Even Points

The firm can make the same stay in business or go
out of business decisions on the basis of price and
average total cost.
Recall, a firm will go out of business if TC > TR , or
A firm will go out of business if TC > P x Q
Let’s divide both side of the above equation by Output:
TC >
Price x Output
Output
Output
ATC
ATC
> Price
< Price
GO OUT OF BUSINESS
OPERATE
20-31
ATC, AVC and MC: Graphing These
Business Decisions
20-32
Questions for Thought and Discussion

Pretend you are the owner of a coffee house. What
would be the difference between shutting down and
going out of business?
•
•

What are the fixed costs?
What are the variable costs?
Why does it take longer to go out of business than to
shut down?
20-33
Varying Factory Capacities: Choosing Plant Size
Each of these ATCs represents a different size factory, with a
different optimum level of output represented by the minimum
point on the ATC curve.
20-34
Varying Factory Capacities: Choosing Plant Size
Answer:
plant size 4
ATC1 has the lowest capacity while ATC5 has the highest.
Which size factory would a firm choose to produce 400 units of output?
20-35
Varying Factory Capacities: Choosing Plant Size
Changes in plant size are long run changes. In the long run, a
firm could be virtually any size provided it has the requisite
financing.
20-36
Current Issue: Wedding Hall or City Hall?

Every wedding, big or small incurs fixed cost and
variable cost.
•
•
Fixed costs: flowers, photographer, the wedding hall, the
gowns, the videographer, tux rentals, clergy.
Variable costs: food and drinks; the number of guest will affect
the size of the wedding hall.

A relatively small wedding that cost $20,000 and might
pull in gifts worth $10,000.

A much larger wedding might cost $100,000 and might
pull in gifts worth $50,000.

Do you go for the large wedding or smaller one?
20-37