Cost Curve ModelChapter 13 completion

Costs of Production• Fixed costs - do not change with quantity of output

• Variable costs - ↑ with quantity of output

• Marginal cost ∆ total cost to make 1 extra unit

Fixed Costs + Variable Costs = Total Costs

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Shape of MC Curve

Shape of MC curve is determined by shape of MP Curve

If MP ↑ => MC ↓

If MP ↓ => MC ↑

MC

Model:•uses average cost curves:•uses economic costs

ATC = TC / Qty producedAVC = TVC / Qty producedAFC = TFC / Qty produced

Cost Curve Model

Cost Curves

Using Average Cost Curves

Quantity of Output

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0 42 6 8 141210

MC

ATC

AVC

AFC

MC hits both ATC & AVC at their minimum

•When MC < ATC => average total cost is falling

•When MC > ATC => average total cost is rising

AFC always declines:

Fixed Costs spread over more output

ATC is U-shaped

Due to high fixed costs

1) Profit = TR – TC

There are several formulas to calculate economic profit:

2) Profit = (Price – ATC) X Qty (most useful formula)

Market Price = P1

If P1 > ATC => Economic Profit

If P1 < ATC => Economic Loss

Cost Curves

Quantity0

Price

MCMC ATCATC

Economies of Scale• Economies of scale = Qty ↑ => ATC ↓

– ATC falls as output increases– Allows for specialization of workers– Leads to more productivity per worker

• Diseconomies of scale = Qty ↑ => ATC ↑ – ATC rises as output increases– coordination problems eventually arise as firms grow in size

• Constant returns to scale- – Qty ↑ => ATC stays the same

Practice Test

Short Run vs. Long Run Costs

• Costs depends on the time horizon considered– In the short run, some costs are fixed– In the long run, all fixed costs become variable costs– Why: Firms have time to change both plant size & labor force

• Therefore, long-run cost curves differ from short-run cost curves

Long Run ATC

Quantity ofCars per Day

0

AverageTotalCost

1,200

$12,000

1,000

10,000

Economiesof

scale Diseconomiesof

scale

Constantreturns to

scale

LRATC

Note! => The “term” economies of scale applies only to long run cost curves

Long Run vs. Short Run ATC• LRATC is always below or on short run ATC curve

– you can be more efficient in long run!

Quantity ofCars per Day

0

AverageTotalCost

1,200

$12,000

1,200

$12,000

1,000

10,000

1,000

10,000

1,000

10,000

Economiesof

scale

Economiesof

scale

Economiesof

scale

Short run ATC

small factory

Short run ATC

small factory

Short run ATC

medium factory

Short run ATC

medium factory

Short run ATC

large factory

Short run ATC

large factory

Diseconomiesof

scale

Diseconomiesof

scale

Diseconomiesof

scale

Constantreturns to

scale

Constantreturns to

scale

LRATC