Recitation 3 Lecture Notes
1. Review any questions from last class.
2. Agenda:
a. Fixed Costs vs. Variable Cost
b. Marginal Cost and Average Cost
c. Marginal Revenue
d. Optimal decision for firm in Short Run
e. Discussion about writing assignment
3. Framework: Story ORANGE JUICE BUSINESS
4. Fixed Costs vs. Variable Costs
a. Definition of Fixed Cost (page 130): A fixed cost is the cost of an input whose
quantity does not raise when output goes up, one that the firm requires to produce any
output at all. The total cost of such indivisible inputs does not change when the output
changes.
i. Examples: Rent, machines
1. Fixed costs are our juicing machine and also could be workers that we
contract.
ii. Average fixed cost= Total Fixed cost/Quantity
b. Definition of Variable Cost (page 130): costs of an input changes with the change of
output
i. Example: oranges, shipment of oranges and then juice
1. Variable costs is the cost (plus transportation costs) of purchasing oranges
ii. Average Variable cost = Total Variable cost/ Quantity
c. Economic Profit: Equals net earnings, in the accountant’s sense, minus the opportunity
costs of capital and of any other inputs supplied by the firm’s owners
d. Total Profit: The total profit of a firm is its net earnings during some period of time. It is
equal to the total amount of money the firm gets from sales of its products (the firm’s total
revenue) minus the total amount that it spends to make and market these products (total
cost)
e. Total revenue: of a supplier firm is the total amount of money it receives from the
purchasers of its products, without any deduction of costs
5. Marginal Cost and Average Cost
a. Average Cost
i. Average Total Cost: Decreases rapidly at first because AFC is decreasing rapidly
and AVC is decreasing also. When the quantity increases AFC is decreasing at a
lesser rate while AVC is now increasing.
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
1. Average Total Cost= Average Fixed cost + Average Variable = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
ii. Average Variable Cost SHAPE: The Average variable cost is downward sloping at
first because of economy of scale (in this example it could come about from being
able to get a better deal from local orange producers by “buying in bulk”). The
Average variable cost starts increasing (diminishing economies of scale) because
the company might have to start getting oranges from different producers that are
farther away, increasing the transportation costs.
b. Marginal Cost
∆𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
∆𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
i. Marginal Cost= (Current Total Cost- Previous Total Cost)/ (Current QuantityPrevious Quantity)
ii. Marginal Cost SHAPE: Downward sloping then upward sloping for the same
reason as Average variable. The reason it drops steeper than AVC is because the
marginal cost tells you how much are those incremental oranges costing you (in
this case from 1000 to 2000 oranges, it’s costing you $350 extra for the extra 1000
oranges), whereas AVC tells you how much are all of the oranges on average
costing you (you still have to buy the first 1000 oranges at 500 and $350 for the
next 1000, making the average price be greater than just extra cost.
6. Marginal Revenue
a. Marginal Revenue: is the addition to total revenue resulting from the addition of one
unit to total output. Geometrically, marginal revenue is the slope of the total revenue
curve at the pertinent output quantity. Its formula is MR1 = TR1 – TR0 and so on.
b. Average Revenue: AR is total revenue divided by quantity
Table
Gallons
of Juice
0
1000
Fixed
Costs
(FC)
1000
1000
Variable
Costs
(VC)
0
500
Total
Costs
(TC)
Average Fixed
Costs (AFC)
Average
Variable Costs
(AVC)
Average Total
Costs (ATC)
Marginal Cost
(Average)
1000+ 0
= 1000
1000+50
0 =1500
FC+VC
1000
500
1000
1000
=1.00
=0.50
𝐹𝐶
𝑉𝐶
𝐺𝑎𝑙𝑙𝑜𝑛𝑠 𝑜𝑓 𝐽𝑢𝑖𝑐𝑒 𝐺𝑎𝑙𝑙𝑜𝑛𝑠 𝑜𝑓 𝐽𝑢𝑖𝑐𝑒
1500
1500−1000
1000
1000−0
=1.50
𝑇𝐶
𝐺𝑎𝑙𝑙𝑜𝑛𝑠 𝑜𝑓 𝐽𝑢𝑖𝑐𝑒
=0.50
∆𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
∆𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
1850−1500
2000
1000
850
1000+85
0 =1850
3000
1000
1100
2100
0.33
0.37
0.70
=0.3
5
0.25
4000
1000
1360
2360
0.25
0.34
0.59
0.26
5000
1000
1660
2660
0.20
0.33
0.53
0.30
6000
1000
2010
3010
0.17
0.34
0.50
0.35
7000
1000
2410
3410
0.14
0.34
0.49
0.40
8000
1000
2860
3860
0.13
0.36
0.48
0.45
9000
1000
3360
4360
0.11
0.37
0.48
0.50
10000
1000
3910
4910
0.10
0.39
0.49
0.55
1000
850
2000
2000
=0.50
=0.43
1850
=0.93
2000
2000−1000
Graph
Adding a market price
If we are given a price, say p=$.55 per gallon of juice, what quantity should the company produce?
The price tells us that every extra unit that we produce we earn an extra $.55
The company’s decision on producing an extra gallon of juice comes down to whether they will get extra
profit from that gallon of juice, i.e. the marginal Profit is greater than zero.
The marginal profit = price – marginal cost



So if you produce a quantity that makes price > marginal cost ===> you get extra profit if you
produce one more gallon = produce more
If you produce a quantity that makes price< marginal cost ====> you get extra losses if you
produce one more gallon ===> produce less
If you produce a quantity that makes price=mc ====> every other gallon before your last gallon
made you profit but adding one more gallon won’t make you extra profit===> produce that
amount
Therefore the company will want to produce gallons of juice until MC=P. In addition to this they want to
produce as much as possible given MC=P so that the fixed costs is less per unit produced
Now we have a relationship between the price of our market and the quantity we produce which is
completely determined by our marginal cost.
Looking at different prices
Could make a table of different prices, say P= .55, .50 (this happens twice so we should use where
MC=.50 at the higher quantity), .45, .35, .30, .25


What happens when we get p=.45?
Our average total cost is $.48 and we are only collecting $.45 from each gallon. We are
losing 8000*.45 – 8000*.48=$-240. Should we close shop? No because if we do we still
have to pay the $1000 fixed cost which is more than the amount we are losing if we stay in
business. We can also see that we are still covering our average variable costs)
What happens at p=.30
Now if we produce at MC=p (which happens at Q=5000) we get our average total cost to
be .53 per gallon which means we are losing .23 dollars per gallon or
5000*.30-5000*.58=$-1150 which is more than our fixed costs so we produce zero. (can
draw the revenue areas and the cost areas on the graphs to give a visual representation)
Could make a table with prices and the corresponding quantities that we found and then plot them on a
graph to find the SUPPLY curve!!
7. Optimal decision for firm in Short Run
a. (Page 155): An optimal decision is one which, among all the decisions that are actually
possible, best achieves the decision maker’s goals. For example, if profit is the sole
objective of some firm, the price that makes the firm’s profit as large as possible is optimal
for that company.
8. Discussion about writing assignment
a. Refer to the Sakai information
b. Be complete, but not verbose
Note: Took an example from the khan academy website that goes over total cost, fixed cost, marginal
cost and the company’s decision process. The links are:
i) http://www.youtube.com/watch?v=7t8gdc3YogM (7:40 minutes) Part 1
Youtube Search: “khan academy Marginal cost and average cost”
ii) http://www.youtube.com/watch?v=xGkE0oHyNhk (6:10 minutes) Part 2
Youtube Search: “khan academy Marginal Revenue and Marginal Cost”
iii) http://www.youtube.com/watch?v=ni0TL4pXG5w Part 3
Youtube Search: “khan academy Marginal Revenue Below Average Total Cost”
Being able to rewind hard parts can be a blessing!