No Free Lunch: Economics for A Fallen World

7 | Production: Man At Work

Short Run Costs

Let's review our discussion on time from chapter 4. For our analysis, we will consider three time periods: market period, short run, and long run.

The entrepreneur has to calculate the best mix of resources to produce a certain level of output, and some asset costs are different than others. As we discussed, an entrepreneur will try to reduce costs to maximize profits. The total costs that an entrepreneur wants to minimize can be divided into fixed costs and variable costs:

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
TC = FC + VC

In the short run, as we've defined, not all inputs are variable—some are fixed. For example, let's say the Camaro SS continues to be a huge hit in 2016. In the short run, fixed costs would include the number of factories; it might take a couple of years to bring a totally new factory online, and it might still take 6-12 months to reconfigure another production line (say from the Impala) to produce additional Camaros. Perhaps the only variable might be labor; GM could either hire other workers and run multiple shifts, or perhaps expand overtime usage (if they thought the increased demand was only temporary). Since fixed costs are fixed, they are the same regardless of quantity. For example, if you produce more cars through the physical plant, the insurance cost for the building will stay the same. Likewise, if you totally shut down production you still have to pay the insurance cost. Variable costs such as labor vary with output quantity and increase as more output is produced. Figure 7.7 shows the relationship between total costs, fixed costs, and variable costs.

Total Cost Curves
Figure 7.7, Total Cost Curves. Total fixed costs do not vary with output and thus are constant in the short run, like property taxes on a factory. Variable costs will rise as output increases per the graph above. An entrepreneur may hire additional workers or add more capital equipment. The variable cost curve shape reflects initial gains from specialization as costs rise more slowly than output, but eventually, diminishing returns causes costs to rise faster than output. The difference between variable cost and total cost by definition is the number of fixed costs, which is constant across the curves, as indicated by the size of the arrows.

Total costs are useful in helping an entrepreneur calculate profits; but calculating average costs informs specific production decisions. Average total (or unit) costs (ATC) guide an entrepreneur to know how much to try and charge for a product. Understanding the relationship between average costs and marginal costs helps an entrepreneur understand whether he or she should expand or decrease production to reduce costs.

In Figure 7.8 we see the graphic representation of the relationship between marginal costs and average total/variable/fixed costs. Recall from our discussion of marginal values: any unit "on the margin" is, at the margin of choice, the next unit that may be produced if incentives change (in the case of production—if the price rises slightly). The marginal cost is the cost to produce the next unit of output. If you are producing 100 units currently, for example, at a cost of $200, you may decide to produce 101 units at a cost of $201. In this case, the marginal cost would be $1, and producing an additional unit would lower the average total cost slightly ($2 each). The marginal cost curve tends to slope downward initially as the benefits of the division of labor and gains from specialization lead to increased production efficiency and thus reduced marginal costs. Eventually, however, production will hit diminishing returns and the marginal cost curve will begin sloping upward.

Average Cost Curves
Figure 7.8, Average Cost Curves. The Average Total Cost curve is U-shaped due to 1) spreading fixed costs over a larger quantity, and ultimately, 2) diminishing returns. Average Variable Cost and Marginal Cost curves reflect the gains from specialization where they slope down and then diminishing returns which drives the curves upward. The MC curve must intersect the ATC and AVC curves at their minimum.

Average fixed costs (AFC) simply takes the total fixed costs (TFC) and divides that total by the quantity produced (i.e., AFC = TFC/Q). As seen in Figure 7.8, the result is a steadily decreasing AFC as the fixed cost is spread out over more and more items produced. Think of it this way: your local amusement park may decide to add a new roller coaster. The purchase price of the roller coaster is fixed, and as the theme park sells more and more tickets, the cost of that roller coaster per ticket goes down as the fixed cost is spread over more riders. Average variable costs (AVC) and average total costs (ATC) are calculated similarly; the total costs are divided by the quantity produced. The distance between the AVC and ATC curve is equal to the AFC as seen by the blue arrows in Figure 7.8.

You should notice that the marginal cost curve intersects both the average variable cost and average total cost curves at their minimum value. This is always the case, and reflects the definition of marginal and average quantities. Let's take a baseball case, for example. If Mike Trout has a batting average of .320, and he hits a hot streak, with his "marginal" average (say the next series) up to .600, what will happen to his overall average? It will go up, reflecting his better performance; perhaps to .322 (depending on how many at-bats he already has that season). We can see the same thing in Figure 7.8; when the marginal value is greater than the average value, the average value will begin to rise. Similarly, if Mike Trout goes into a slump and is only batting .150 during a road trip, his overall batting average will drop. We also see this effect in Figure 7.8; when marginal costs are below average costs, average costs are decreasing. Students can see the same thing in their grade point average (GPA). If your overall GPA is 3.5 and you have a 4.0 semester, your cumulative GPA will rise. If instead you "party" all semester and barely pull out a 2.0, your cumulative GPA will fall!

Why would an entrepreneur care about average vs. marginal costs? Well, for tax purposes, he or she will need to calculate profits based on total profits and total costs. These total costs are applied against the total quantities produced, giving an average (per unit) cost. But the marginal cost is always the one that must guide his or her decision whether to expand or decrease production. Do not immediately think, however, that a profit maximizing entrepreneur will expand output if marginal costs are decreasing and decrease production if marginal costs are rising. We'll see later in this chapter that an entrepreneur will want to expand production as long as marginal costs are lower than marginal revenues.

Next Page: Relationship between Cost and Product Curves »


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