Okay, so what do costs look like?
Frankly, I have very little idea, but I do know what product curves look like, so I can
start from there.
How?
Well, variable costs are related to variable inputs, right?
The total product curve is the relationship between the variable resource, labor, and
the amount of output.
I can use this as a stepping stone to where I want to be, which is a relationship between
output and the cost of the variable resource.
All I need to do is attach a price tag to my labor.
We usually refer to the price of labor as wage, so let's assume that each unit of labor
costs $10.
In the new diagram, everything looks largely the same, except that I replace one unit of
labor with $10, two units of labor was $20, three units of labor with $30, and so on.
Now I have a diagram illustrating the relationship between the output that I produce and my labor
cost, or variable cost.
The only issue I have with this diagram is that it's inconsistent with the market, i.e.
supply and demand, diagrams that we’ve spent so much time on.
Did you notice with the market diagram, price (which is in dollars) is on a vertical axis,
and quantity is on the horizontal, whereas here, we have quantity of output on the vertical
axis and the cost (in dollars) on the horizontal.
For reasons that you will soon understand, we’re going to want the cost diagram to
be consistent with the market diagram.
How do we achieve this?
It’s pretty simple, actually; we just need to flip the axes in the cost diagram, so that
they match.
So now we have a cost diagram.
Notice we can ignore the upper portion, since no producer will want to be paying out more
money for less output.
But this doesn't represent all of our costs, does it?
Recall that this diagram considers only the labor cost, or the variable cost – what
do the cost of the fixed resources look like?
If you think back to our puppy example, the overhead cost was $1500 if we had no puppies,
$1500 if we had one puppy, $1500 if we had two puppies… in fact, $1500 had to be paid,
no matter how many puppies.
What does this mean for our cost diagram?
Well, it means that for every level of output, all we have to do is tack on the total fixed
costs -- in our puppy example, it was $1500 -- to whatever variable costs we have.
What we get as a result is a new cost curve: our total cost curve.
It's really just our total variable cost curve, shifted upward by the amount of those fixed
costs.
Let's take a look at how the various costs could be calculated.
In this cost table, the business owner can produce anywhere from 0 to 10 units of output.
One thing that I know at this point is that the total fixed cost associated with not producing
any units is $60.
What's nice about this information is the total fixed cost is the same, no matter what
the output level, so I can fill in the rest of this column easily.
But what about the rest of this alphabet soup of costs?
Let me go through them one at a time.
We already know that TFC is total fixed cost, and TVC is total variable cost.
TC stands for total cost, and can be calculated by adding TFC and TVC.
What about AFC?
This is average fixed cost, or the fixed cost per unit of output produced.
The fixed cost per unit is going to tell me, for each unit that I'm producing, how much
of that is coming from those unchangeable, overhead costs.
To calculate, just take the total fixed cost and divide it by the number of units being
produced.
AVC, then, is average variable cost, or the variable cost per unit of output produced.
I might look at this if I am the firm owner, and I want to know how much of my cost per
unit is coming from my payroll and benefits that I’m paying my employees.
I'll calculate this by taking the total variable cost and dividing by the number of units being
produced.
ATC is the average total cost, or the entire cost of producing a unit.
ATC can actually be calculated two ways: either by taking the total cost of production and
dividing by the number of units, OR by taking the fixed cost per unit and the variable cost
per unit, and adding them together.
Finally, MC stands for marginal cost, or the additional cost of producing an additional
unit of output.
MC can be found by taking the change in my total cost over the change in quantity – or,
since variable cost is really the only component that changes, marginal cost is the change
in total variable cost over the change in the quantity.
TIME TO THINK: It's easy to get caught up in the formulas and calculations, and forget
the intuition.
So before our next class, here’s what I want you to do: step back and take a look
at the pattern exhibited by each of these different costs.
What will each one look like if you, the business owner, produce more output?
How much output do you think you would choose to produce?
NEXT TIME: Do we really need all these graphs?
TRANSCRIPT00(MICRO) EPISODE 23: COST CURVES