PRODUCTION AND COSTS:
FIRM COSTS
AP Economics
Mr. Bordelon
Cost Curves
• Fixed cost. Cost that does not depend on the quantity of
output produced. It is the cost of the fixed input.
• Variable cost. Cost that depends on the quantity of
output produced. It is the cost of the variable input.
• Total cost. 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
• Total cost curve. Shows how total cost depends on
quantity of output.
Total Cost Curve
Total Cost Curve
This table shows GM
Farms’ total cost curve
from the sum of their
variable cost and their
fixed costs.
In order to transform
information from the
production function to
total cost, we need to
know how much George
and Martha pay for
inputs.
For our purposes here,
we’re assuming that
George and Martha
have a fixed cost of
$400 for the use of the
land. They will pay $400
whether they grow one
bushel or 100.
Sometimes shows up on
AP Exam (and in real
life) as “overhead cost.”
Total Cost Curve
Additionally, we will assume
that George and Martha must
pay $200 for each worker.
George and Martha know that
the number of workers they
must hire depends on the
amount of wheat they intend to
produce.
The cost of labor equals the
number of workers times $200.
This is the variable cost.
Where are we getting the
quantity of bushels from (on the
x-axis)?
Adding VC and FC gives us
TC, which can be graphed out.
Total Cost Curve
Total cost curve slopes
upward, like the total product
curve. Due to the increasing
variable cost, the more output
produced, the higher the
farm’s total cost.
However, the total cost curve
gets steeper. The slope of the
total cost curve is greater as
the amount of output
produced increases.
What is ultimately causing this
curve to slope upward? HINT:
same thing that causes the
total product curve to slope
downward.
Total Cost Curve
Total cost curve slopes
upward, like the total
product curve. Due to the
increasing variable cost,
the more output produced,
the higher the farm’s total
cost.
However, the total cost
curve gets steeper. The
slope of the total cost
curve is greater as the
amount of output produced
increases.
The slope of the total cost
curve is due to
diminishing returns on
the variable input.
Marginal Cost
• Marginal cost. Added cost of doing something one more
time. Change in total cost generated by producing one
more unit of output.
• MC = ΔTC/ΔQ
Marginal Cost
Marginal Cost
Marginal Cost
Marginal Cost
Marginal cost is
equal to the slope
of the total cost
curve.
What was the
slope of the total
product curve?
Marginal Cost
Marginal cost is
equal to the slope
of the total cost
curve.
Marginal product is
equal to the slope
of the total product
curve.
In this case, this is
the total cost curve
of Selena’s
Gourmet salsas,
plotted out
according to the
table.
Marginal Cost
Marginal cost at
Selena’s Gourmet
Salsas rises as output
increases. And because
marginal cost equals the
slope of the total cost
curve, a higher marginal
cost means a steeper
slope.
Why does the marginal
cost curve slope
upward?
Marginal Cost
Marginal cost at Selena’s
Gourmet Salsas rises as
output increases. And
because marginal cost
equals the slope of the
total cost curve, a higher
marginal cost means a
steeper slope.
The marginal cost curve
slopes upward because
there are diminishing
returns to inputs.
As output increases, the
marginal product of the
variable input declines.
More and more of the
variable input must be
used to produce each
additional unit.
Since each additional
variable unit must be paid
for, the additional cost per
additional unit also
increases! Sexy, sexy.
Marginal Cost
The flattening of the
total product curve as
output increases and
the steepening of the
total cost curve as
output increases are
just flip-sides of the
same coin.
As output increases,
the marginal cost of
output also increases
because the marginal
product of the variable
input decreases.
Marginal Cost
Diminishing marginal returns
•Total product curve. If quantities of other inputs are fixed, marginal product
of an input falls as more of that variable input is used.
•Total cost curve. If quantities of other inputs are fixed, marginal cost of
output increases as more of that variable input is used (marginal product of the
variable input decreases).
Average Total Cost
• Average total cost. Total cost divided by quantity of
output produced.
• ATC = TC/Q
• ATC tells producer how much the average unit of output
costs to produce.
• Contrast: marginal cost tells producer how much one more unit of
output costs to produce.
Average Total Cost
What happens to ATC as the quantity of output increases?
Average Total Cost Curve
ATC Curve
This is the curve
according to the data
plotted in the average
cost table for Selena’s
Gourmet salsas. Notice
the distinctive U-shape.
Think of it as a warm
economic hug. It
reflects how ATC first
falls and then rises as
output increases.
But why does it do that?
Well...you’ll need to take
a look at average fixed
costs and average
variable costs.
Take a deep breath.
Average Fixed and Variable Costs
• Average fixed cost (AFC). Fixed cost divided by
quantity of output.
• AFC = FC/Q
• Average variable cost (AVC). Variable cost divided by
quantity of output.
• AVC = FC/Q
AFC/AVC/ATC
AFC/AVC/ATC
ATC is the sum of the
AFC and AVC. It has
that economic hug
because AFC and AVC
move in opposite
directions as output
increases.
Math: AFC decreases
as more output is
produced because FC
(numerator) is a fixed
number but Q
(denominator) increases
as more is produced.
SS: As we produce
more, our FC get spread
out over more units
produced. AFC will drop
as we make more.
AFC/AVC/ATC
Math: AVC increases as
output increases.
SS: Each additional unit of
output adds more to VC
because increasing
amounts of variable input
are required to make
another unit. We’re going
to make need more stuff
than we needed before to
keep making products.
Spreading effect. Larger
the output, greater quantity
of output over which FC is
spread, leading to lower
AFC.
Diminishing returns effect.
Larger the output, the
greater the amount of
variable input required to
produce additional units,
leading to higher AVC.
AFC/AVC/ATC
At low levels of output,
spreading effect is more
powerful because even
small increases in output
cause large reduction in
AFC. At low levels of
output, spreading effect
dominates diminishing
returns effect and causes
ATC to slope downward.
At high levels of output,
AFC is already small, so
increasing output only has
a small spreading effect.
AFC/AVC/ATC
Diminishing returns grow
more as output
increases.
When output is large,
diminishing returns
effect dominates
spreading effect,
causing ATC to slope
upward.
At the bottom of the
economic hug ATC,
point M, the two effects
exactly balance each
other out.
At point M, ATC is at its
minimum level, the
minimum ATC. It’s no
coincidence that this is
also the point where
ATC = MC.
AFC/AVC/ATC Summary
Marginal cost curves
slope upward.
Diminishing returns that
make an additional unit
of output more costly to
produce than the one
before.
AVC curve slopes
upward. Diminishing
returns, but flatter than
MC curve. Higher cost
of an additional unit of
output is averaged
across all units, not just
the additional unit.
AFC slopes downward.
Spreading effect—larger
the output, greater
quantity of output over
which FC is spread,
leading to lower AFC.
AFC/AVC/ATC Summary
ATC slopes downward
initially, then upwards.
At low levels of output,
spreading effect
dominates diminishing
returns effect and causes
ATC to slope downward.
When output is large,
diminishing returns effect
dominates spreading
effect, causing ATC to
slope upward.
At the bottom of the
economic hug ATC, point
M, the two effects exactly
balance each other out.
Marginal cost intersects
ATC crossing at
minimum ATC. Lowest
point. At point M, ATC is
at its minimum level, the
minimum ATC.
ATC = MC.
Minimum Average Total Cost
• Minimum-cost output. Quantity of output at which ATC
is at its lowest. Corresponds to the bottom of the Ushaped ATC curve.
• Why might this be important?
Minimum Average Total Cost
• Minimum-cost output. Quantity of output at which ATC
is at its lowest. Corresponds to the bottom of the Ushaped ATC curve.
• Minimum-cost output gives producers an idea of just how
much they can produce at the lowest cost possible.
Minimum ATC
• The bottom of the U is at the level of output where MC
curve crosses the ATC curve.
1. At minimum-cost output, ATC is equal to MC.
2. When output is less than minimum-cost output, MC is
less than ATC and ATC is decreasing.
3. When output is more than minimum-cost output, MC is
greater than ATC and ATC is increasing.
Minimum ATC
1. ATC = MC (point M)
When MC equals
ATC, at the bottom
of the ATC curve
because only there
is ATC neither
increasing or
decreasing.
Minimum ATC
2.
MC < ATC, ATC decreasing.
If MC < ATC, producing the
extra unit lowers ATC.
(A1 to A2)
MC of producing an
additional unit of output is low
(MCL on MC curve).
When MC of producing next
unit of output is less than
ATC, increasing production
reduces ATC.
Any quantity at which MC is
less than ATC must be on the
downward sloping segment
of the ATC curve.
Minimum ATC
3.
MC > ATC, ATC increasing.
If MC > ATC, producing the
extra unit raises ATC. (B1 to
B2)
MC of producing an
additional unit of output is
high (MCH on MC curve).
When MC of producing next
unit of output is more than
ATC, increasing production
increases ATC.
Any quantity of output where
MC is more than ATC must
be on the upward sloping
segment of the ATC.
MC Curve Slope
• Diminishing returns lead to
a marginal product curve
that always slopes
downward and a marginal
cost curve that always
slopes upward.
• In reality, economists
believe that marginal cost
curves slope downward as
a firm increases its
production from zero up to
some low level, sloping
upward only at higher
levels of production.
MC Curve Slope
• The initial downward
slope happens because
a firm finds that when it
starts with only a very
small number of
workers, employing
more workers and
expanding output allows
workers to specialize.
This, in turn, lowers the
firm’s MC at it expands
output.
MC Curve Slope
• Specialization leads to
increasing returns to the
hiring of additional
workers, and leads to a
MC curve that initially
slopes downward.
• Once specialization is
exhausted, diminishing
returns to labor set in
and the MC curve
changes direction and
slopes upward.
MC Curve Slope
• In any case, we see
the same patterns as
before:
• ATC is U-shaped
• MC curve passes
through point of
minimum ATC
Bob’s Lemonade Stand
• Bob has done an exhaustive study on the costs of producing cups of
lemonade, as he is wont to do. He must pay $50 every day to the city for the
right to sell lemonade. This is a fixed cost because it doesn’t matter if he
sells 50 cups or zero. He must also pay $25 for every employee he hires.
This is his variable input (and thus, his variable cost).
Units of Labor
Total Product
(# of
cups/hour)
Variable Cost
(VC)
Fixed Cost
(FC)
Total Cost (TC
= FC + VC)
0
0
$0
$50
$50
1
8
$25
$50
75
2
18
50
$50
100
3
26
75
$50
125
4
32
100
$50
150
5
36
125
$50
175
6
38
150
$50
200
Bob’s Lemonade Stand
• FC in this case is relatively
horizontal. Notice the cost
is paid even when zero
cups of lemonade are
produced.
• VC rises as more output is
produced and begins to
rise more and more quickly
at higher levels of output.
• TC has the same shape as
VC because it is simply VC
plus a constant level of
FC. The vertical distance
between TC and VC is
always FC ($50).
Bob’s Lemonade Stand
• MC = ΔTC/ΔQ = Δ(VC + FC)/ΔQ = ΔVC/ΔQ
• Marginal cost is the slope of total cost or variable cost.
• The following table shows MC for the lemonade stand.
Notice that the change in output is in 8 units (this affects
MC calculation).
Output
MC
8
3.13
18
2.50
26
3.13
32
4.17
36
6.25
38
12.50
ATC
AVC
AFC
Bob’s Lemonade Stand
• Diminishing returns. MC
initially declines, but eventually
increases as more output is
produced. Diminishing returns
to labor in production function
cause this.
• As output increases, marginal
product of variable input (labor)
decreases. More and more
labor must be used to produce
each additional unit of output.
• Since each unit of labor must be
paid for, the additional cost per
additional unit of output also
increases.
Output
MC
8
3.13
18
2.50
26
3.13
32
4.17
36
6.25
38
12.50
ATC
AVC
AFC
Bob’s Lemonade Stand
• ATC. ATC = TC/Q
• AP additional terms:
average cost, unit cost,
per unit cost.
• AVC. AVC = VC/Q
• AFC. AFC = FC/Q
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• AFC. Decreases as
more output is produced.
FC is constant, but Bob
is dividing by more and
more cups of lemonade.
He must pay $50 for the
sidewalk, so when he
divides by more cups of
lemonade, FC is spread
out over more output.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• AVC. As output
increases, and
diminishing returns
becomes a major
issue, the upward pull
of AVC becomes
stronger and begins to
pull ATC upward.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• ATC. Initially declines,
but eventually increases
as more output is
produced.
When more output is
produced, the spreading
effect lowers ATC as
more output is produced.
When more output is
produced, the
diminishing returns effect
causes ATC to increase.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• Spreading effect. Larger
the output, the greater
the quantity of output
over which FC is spread,
leading to lower AFC.
• Diminishing returns
effect. Larger the
output, the greater the
amount of variable input
required to produce
additional units, leading
to higher AVC.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• At low levels of output,
the spreading effect is
very powerful because
even small increases in
output cause large
decreases in AFC, and
pulls down ATC.
• As output increases, and
diminishing returns
becomes a major issue,
the upward pull of AVC
becomes stronger and
pulls ATC upward.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• MC curve intersects
ATC and AVC at their
respective minimum
points.
Output
MC
ATC
AVC
AFC
8
3.13
9.38
3.13
6.25
18
2.50
5.56
2.80
2.78
26
3.13
4.81
2.88
1.92
32
4.17
4.69
3.13
1.56
36
6.25
4.86
3.47
1.39
38
12.50
5.26
3.95
1.32
Bob’s Lemonade Stand
• Minimum ATC
• ATC decreases as long as MC < ATC.
• As MC increases, so that MC > ATC, ATC will increase.
• If MC of next unit is equal to ATC, ATC will not change.
• Another example: GPA
• If overall GPA is 3.0, and student earns a 4.0, overall GPA will
increase.
• If overall GPA is 3.0, and student earns a 3.0, overall GPA will stay
the same.
• If overall GPA is 3.0, and student earns a 2.0, overall GPA will
decrease.
Bob’s Lemonade Stand
• Looking at the MC
curve for the lemonade
stand shows that the
MC initially decreases.
Bob’s Lemonade Stand
• MC can initially
decrease due to
specialization of labor
in the production
function.
• Before diminishing
returns happens,
imagine Bob divides
up the tasks according
to certain talents.
Bob’s Lemonade Stand
• Bob is great with customers, so
she sells the lemonade, greets
customers, etc.
• Bobbette, Bob’s employee, is
extremely fast in the kitchen,
squeezing lemons, mixing
sugar, and dreaming of lemon
cupcakes.
• With this kind of specialization,
marginal product increases.
• However, when Bob hires Bobb,
Bobby, and Bobberino
McBobster, diminishing returns
are experienced, and MC
increases.