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In a supplemental note to a reprint of the classic "Cost Curves and Supply Curves," Jacob Viner relates his confusion

about how long-run and short-run cost curves relate. 1 He asked a draftsman to make the long-run curve a U-shaped envelope that consisted of the minimum points on all short-run curves. The draftsman pointed out the impossibility of this construction, causing Viner to realize that what he really wanted was that the long-run curve consist of points on the the average cost curves at the minimum-cost scale for each quantity, the well-established envelope. Despite more than a half-century of fine-tuning, imprecision about how the various curves— long-run and short-run, average and marginal—relate remains a source of potential confusion, at least when drafting is involved. This paper presents a set of Excel workbooks (see footnote 4 for information on downloading the workbooks) that produce graphs of long-run and short-run cost curves that are consistent. That is, the long-run curve is the proper envelope of the short-run curves and the average and marginal curves (both long-run and short-run) are consistent. Before presenting the workbooks, we review the relationships that must hold if graphs are to represent economic relationships accurately. The paper is organized as follows. The next section reviews textbook materials, how the various long-run and short-run curves relate to each other. It is followed by a section that discusses the specific functional forms we use to illustrate these relationships. Then a section describes how a set of Excel workbooks provides a graphic representation of these curves and describes the options the user has when employing these workbooks. Finally, we extend the analysis briefly to include revenue as well as costs, for both price-taking and price-making firms.

The Cost Curves and How They Bend
The typical microeconomics textbook and classroom development of cost curves consists of two parts. One shows how the per-unit cost curves (average and marginal) relate to total costs. The second shows how long-run cost curves (total, average, and marginal) relate to their short-run counterparts. First consider the relationships between average and marginal curves. When the average value involves a linear relationship, the representation is simple: the marginal curve is half the horizontal distance to the average curve. For nonlinear cost curves, however, drawing the marginal curves so that they correspond to the average curve (or vice versa) can be tedious. Too often we simply sketch a marginal cost curve that cuts the average cost curve at its minimum point and assume that this is good enough. Even textbook authors commit this error fairly frequently. (This is not an exercise in textbook bashing. We do not cite the textbooks that commit the errors noted below. Readers may contact the authors for examples.) Failure to draw the curves consistently causes at least two inconsistencies. One is that the quantity at which marginal revenue equals marginal cost will not be the quantity at which profit—(price less average cost) times quantity—is, in fact, maximized. The other is that profit as defined above will not equal profit, defined as the area between the marginal revenue and marginal cost curves. One of the leading principles textbooks contains a graph in which the area

but the occasional error occurs. The third condition establishes limits on the orders of polynomials that can be employed. we determined that the following curves perform quite well. and quantity. The representation of long-run vs. when the average curves are tangent. This requires that the functional form used be defined by two parameters. For tractability. Such a discrepancy is large enough to confuse students. After considerable experimentation. the marginal curves must intersect. 3 The short-run total cost curve’s form is: . it is easy to overlook this necessary relationships. Generally textbook authors are careful to get this right (or to avoid it by drawing sections of the long-run marginal curves that do not approach the point of necessary intersection). Each of the restrictions cited above provides two conditions at some specified quantity (one for the average function's average value and the other for its derivative. a common error is to forget that. the average and marginal curves must derive from the same total cost curve. the marginal value).between the marginal revenue curve and the marginal cost curve is roughly two thirds larger than the area defined in terms of price. The long-run total cost curve has the form: 2 1. the accompanying marginal cost curves must intersect. we use the polynomial form.   For both long-run and short-run curves. average cost. Certainly in hand-drawing examples for classroom or for examinations. When drawing the long-run/short-run per-unit curves.5. To summarize: For representations of cost curves to be consistent. Functional Form Our task is to define a family of long-run cost curves and short-run cost curves such that the above interrelations can be ensured. One other condition must be imposed if the long-run average (or total) cost curve is to be an envelope consisting of minimum points on a series of short-run average (or total) curves:  The short-run average cost curve must exhibit more curvature than its long-run counterpart (or equivalently the short-run marginal cost curve must intersect its long-run counterpart from below). LTC = aQ2 + bQ0. At the quantity for which long-run and short-run average cost curves are tangent. short-run curves contains the above difficulties and at least one more. the conditions below must pertain.

that SAC approach a specific finite value as Q approaches zero and that fixed cost be a specified fraction of total cost at a specified value of Q. The first two sheets in the workbook report the cost curves consistent with this information. Implementing this form requires two arbitrary impositions. to the "Definitions" sheet or to the table on this sheet on which the graphs are built. we add a set of worksheets for short-run curves. The user provides two pieces of data that establish the long-run cost curves.2. we allow considerable flexibility. Rather than encumber the analysis with such impositions (which can result in absurd results like downward-sloping total cost curves). average variable cost. First. then. the user may change the size of the increments between adjacent observed quantities). STC = mQ3 + n. based on the functional form: 2'. the next sheet shows the long-run total cost and the associated per-unit (average and marginal) curves. the long-run average cost at that quantity (C0). SAC = p + q(Q – Q*)2 (or equivalently SAC = rQ2 + sQ + t). Circumventing this difficulty involves arbitrary impositions on the functional form. (Also. The user may type a chosen value for the variables or may use the scroll bars. These are the quantity at which the long-run cost curve is minimized and the long-run average cost at that quantity. This form for the STC has one drawback: The average variable cost curve approaches zero as quantity decreases. The third sheet shows the per-unit short-run curves: short-run average cost. The first of this set of sheets returns the long-run and short-run total cost curves (and associated tabled values). short-run marginal cost. The user provides a quantity at which long-run total cost equals short-run total cost. 4 Consider first the workbook that relates to costs alone. and average fixed cost. The figure below is representative. The Spreadsheets To make the workbooks as useful as possible. The next three sheets involve the short run. The user specifies the quantity at which long-run average cost is minimized (Q 0). The other two buttons provide navigation. The resulting short-run average cost at Q 1 is reported along with the graphs of the pertinent average and marginal relationships. The "Reset Values" button returns the values to their default values. the total cost curve (both the graph and a table of points on the graph) appears. and the quantity at which longrun and short-run average cost curves are tangent (Q 1). The next sheet does the same for per-unit curves. . for purposes of controlling appearance.

an additional set of graphs based on a cubic shortrun cost curve is appended. Worksheet from CostCurves_Basic. . the choice of functional form for the long-run curves dictates that AVC and SMC achieve their minimum at a quantity of zero. this implies that the firm’s short-run supply curve begins at the origin. To allow more flexibility. Figure 2 shows one such curve. Click on the title to download the workbook. Inter alia.Figure 1. As noted above and as observed in Figure 1. The sheets described above provide an accurate drawing of long-run and short-run cost curves. depicting the pertinent relationships among them.

we add two more workbooks that show revenue as well as cost. this one for a price-making firm.5 The sheets that show per-unit costs now also show the demand curve and the marginal revenue curve. Figure 3 shows one of the graphs. The sheets that previously showed total cost now also show total revenue and profits along with total cost. but the table reminds the user that the firm will behave differently given more time to adjust.Figure 2. the profitmaximizing quantity (and. Costs and Revenue While the primary purpose of this article is to provide an easy way to depict cost curves accurately. the user specifies a price. the price) and the maximum profit level are shown. for the price-making firm. The graph shows the short run only. The first depicts a price-taking firm. the price intercept for the demand curve. the second a price-making firm. In each case. In the former. . Worksheet from CostCurves_quadratic_AVC Click on the title to download the workbook. in the latter.

Instructors may also use the workbooks as the basis for homework assignments. This paper provides a means to draw total and per-unit cost curves for either the short run or the long run and to depict the relationship between costs in the short run and the long run. Worksheet from CostCurves_w_revenue Click on the title to download the workbook. whose grasp of graphical representations is often tenuous at best. The analysis also incorporates revenue relationship. The spreadsheets can be used for developing displays in classroom instruction and for handouts. Conclusion It is important that we represent economic relationships accurately. or . The main purpose of the paper is to present the instructor a way to draw these relationships accurately using Microsoft Excel. Failure to do so can confuse students. Students can explore how changes in the model's parameters affect efficient output levels and the resulting levels of profits. thereby showing how profits relate to production.Figure 3.

and marginal ("for each additional unit") cost curves. Some are applicable to the short run. all related to each other. including total and average cost curves. which are the equal to the differential of the total cost curves. the long run avg cost curve must comprise of all the lowest points of each of the short run avg cost curve because no firm will operate at a level of higher costs in the long run than in the short run. productively efficient firms use these curves to find the optimal point of production (minimizing cost). a cost curve is a graph of the costs of production as a function of total quantity produced. both curves are u shaped the short run avg cost curve rising because of labour specialisation and better spreading of fixed costs and it rises due to the law of diniminshing returns. others to the long run. and profit maximizing firms can use them to decide output quantities to achieve those aims. In economics. There are various types of cost curves. the long run avg cost curve must always be equal to or lie below any short run avg cost curve because in the long run all factors of production can be variable. each of which refers to a particular scale of operation. the long run avg cost curve falls because of economies of scale and rises because of dis-economies.The relationship between these two curves is that a long run average cost curve consists of several short run average cost curves. In a free market economy. Contents             1 Short-run average variable cost curve (SRAVC) 2 Short-run average total cost curve (SRATC or SRAC) 3 Long-run average cost curve (LRAC) 4 Short-run marginal cost curve (SRMC) 5 Long-run marginal cost curve (LRMC) 6 Graphing cost curves together 7 Cost curves and production functions 8 Relationship between different curves 9 Relationship between short run and long run cost curves 10 U-shaped curves 11 See also 12 Notes .

Short-run total cost is given by STC = PKK+PLL. and L is the quantity of labor used. when at least one factor of production is fixed. as STC / Q: SRATC or SRAC = PKK/Q + PLL/Q = PK / APK + PL / APL. From this we obtain short-run average cost. where APK = Q/K is the average product of capital and APL = Q/L is the average product of labor. denoted either SATC or SAC. L is the quantity of labor used. A perfectly competitive and productively efficient firm organizes its factors of production in such a way that the average cost of production is at the lowest point. Short-run average total cost curve (SRATC or SRAC) Typical short run average cost curve The average total cost curve is constructed to capture the relation between cost per unit of output and the level of output.[1]:191 . 13 References Short-run average variable cost curve (SRAVC) Average variable cost (which is a short-run concept) is the variable cost (typically labor cost) per unit of output: SRAVC = wL / Q where w is the wage rate. K is the quantity of physical capital used. PL is the unit price of labor per unit time (the wage rate). and Q is the quantity of output produced. In the short run. This is at the minimum point in the diagram on the right. and is typically drawn as U-shaped. ceteris paribus. The SRAVC curve plots the short-run average variable cost against the level of output. this occurs at the output level where it has enjoyed all possible average cost gains from increasing production. where PK is the unit price of using physical capital per unit time.

and the industry tends naturally to become a monopoly. Natural . All points on the line represent least-cost factor combinations.[3]:259 does not imply that production levels other than that at the minimum point are not efficient. In some industries. This result. marked as Q2 in the diagram.[3]:232 The LRAC curve is created as an envelope of an infinite number of short-run average total cost curves. the equilibrium level of output corresponds to the minimum efficient scale. and hence is called a natural monopoly. the bottom of the LRAC curve is large in comparison to market size (that is to say. points above the line are attainable but unwise. when all productive inputs' usage levels can be varied. The behavioral assumption underlying the curve is that the producer will select the combination of inputs that will produce a given output at the lowest possible cost. one must not confuse it with the long-run marginal cost curve. each based on a particular fixed level of capital usage. All points along the LRAC are productively efficient. while points below are unattainable given present factors of production. which is the cost of one more unit.[3]:235 This mistake is recognized as Viner's Error.[2]:210 Long-run average cost curve (LRAC) Typical long run average cost curve The long-run average cost curve depicts the cost per unit of output in the long run—that is. Average fixed cost continuously falls as production increases in the short run. it is always declining and economies of scale exist indefinitely).[3]:234 Contrary to Viner[citation needed]. because K is fixed in the short run. the envelope is not created by the minimum point of each short-run average cost curve. Given that LRAC is an average quantity. which implies production is at a level corresponding to the lowest possible average cost.[3]:235 The typical LRAC curve is U-shaped.Short run average cost equals average fixed costs plus average variable costs. but not all are equilibrium points in a long-run perfectly competitive environment. reflecting increasing returns of scale where negatively-sloped. This means that the largest firm tends to have a cost advantage. by definition. for all intents and purposes. constant returns to scale where horizontal and decreasing returns (due to increases in factor prices) where positively sloped.[citation needed] In a long-run perfectly competitive environment. The shape of the average variable cost curve is directly determined by increasing and then diminishing marginal returns to the variable input (conventionally labor). This is due to the zero-profit requirement of a perfectly competitive equilibrium.

holding other variables..monopolies tend to exist in industries with high capital costs in relation to variable costs. reaches a maximum value and then continuously falls as production increases.e.[3]:312 Short-run marginal cost curve (SRMC) Typical marginal cost curve A short-run marginal cost curve graphically represents the relation between marginal (i. a long-run concept. reaches a minimum value and then increases. Marginal cost is relatively high at small quantities of output. incremental) cost incurred by a firm in the short-run production of a good or service and the quantity of output produced. Thus marginal cost initially falls.[1]:191 For most production processes the marginal product of labor initially rises. then rises.[3]:226 Long-run marginal cost curve (LRMC) The long-run marginal cost curve shows for each unit of output the added total cost incurred in the long run. The long-run marginal cost curve tends to be flatter than its short-run counterpart due to increased input flexibility as to cost minimization. that is. When the marginal cost curve is above an average cost curve the average curve is rising. like technology and resource prices. Stated otherwise. This curve is constructed to capture the relation between marginal cost and the level of output. constant.[2]:209 The marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. such as water supply and electricity supply. When the marginal costs curve is below an average curve the average curve is falling. reaches a minimum value. Marginal cost equals w/MPL. The long-run marginal cost curve intersects the long-run . then decreasing marginal returns (and the law of diminishing marginal returns). which is a short-run concept. rather than the law of diminishing marginal returns. The marginal cost is shown in relation to marginal revenue (MR). marginal cost declines.[4] The long-run marginal cost curve is shaped by economies and diseconomies of scale. the incremental amount of sales revenue that an additional unit of the product or service will bring to the firm. the conceptual period when all factors of production are variable so as minimize long-run average total cost. This shape of the marginal cost curve is directly attributable to increasing. LRMC is the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable. then as production increases. The marginal cost curve is U-shaped. This relation holds regardless of whether the marginal curve is rising or falling.

In a perfectly competitive market the price that firms are faced with would be the price at which the marginal cost curve cuts the average cost curve. Cost curves and production functions Assuming that factor prices are constant.. if there are increasing returns to scale in some range of output levels. firms are assumed to be in a perfectly competitive market. the firm has economies of scale (i. In this case. If. . is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale. Likewise.[2] The variable cost curve is the inverted short-run production function or total product curve and its behavior and properties are determined by the production function.[1]:208 When long-run marginal costs are below long-run average costs.e. average costs are rising. In this diagram for example. Long-run marginal cost equals short run marginal-cost at the least-long-run-average-cost level of production. at the borderline between economies and diseconomies of scale).average cost curve at the minimum point of the latter. LRMC is the slope of the LR total-cost function. Graphing cost curves together Cost curves in perfect competition compared to marginal revenue Cost curves can be combined to provide information about firms.e. then it can be shown[5][6][7] that at a particular level of output. then the above conclusions are modified.[1]:207 When long-run marginal costs are above long run average costs. long-run average costs are falling (as to additional units of output).[1]:209 [nb 1] Because the production function determines the variable cost function it necessarily determines the shape and properties of marginal cost curve and the average cost curves.. it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale.[2] If the firm is a perfect competitor in all input markets. however. For example. and has neither economies nor diseconomies of scale if it has constant returns to scale. the production function determines all cost functions. the firm is not a perfect competitor in the input markets. with perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i. and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases.

the latter curve is rising. Therefore the SATC curveis also tangent to the LRATC curve at the cost-minimizing level of output. then the latter curve is falling.[11]:292-299 Average cost functions are the total cost function divided by the level of output. At all other levels of production STC will exceed LRTC.but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost. then the firm could have diseconomies of scale in that range of output levels. SMC = LRMC. if the firm is able to get bulk discounts of an input.[2]:230[8]:228-229 The STC curve can lie wholly ―above‖ the LRTC curve with no tangency point. The STC curve cannot cross (intersect) the LRTC curve. then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range. o If MC equals average variable cost. then average variable cost is at its minimum value. Therefore when STC is tangent to LTC. ATC = AFC + AVC The MC curve is related to the shape of the ATC and AVC curves:[8]:212 o At a level of Q at which the MC curve is above the average total cost or average variable cost curve. o If MC equals average total cost.[10]:256 One STC curve is tangent to LRTC at the long-run cost minimizing level of production.[9]     Each STC curve can be tangent to the LRTC curve at only one point. . then average total cost is at its minimum value. Relationship between different curves        Total Cost = Fixed Costs (FC) + Variable Costs (VC) Marginal Cost (MC) = dC/dQ. Relationship between short run and long run cost curves Basic: For each quantity of output there is one cost minimizing level of capital and a unique short run average cost curve associated with producing the given quantity. MC equals the slope of the total cost function and of the variable cost function Average Total Cost (ATC) = Total Cost/Q Average Fixed Cost (AFC) = FC/Q Average Variable Cost = VC/Q. At the point of tangency LRTC = STC.[8]:212 o If MC is below average total cost or average variable cost. Conversely. At all other levels of production SATC > LRATC[11]:292-299 To the left of the point of tangency the firm is using too much capital and fixed costs are too high. To the right of the point of tangency the firm is using too little capital and diminishing returns to labor are causing costs to increase.[12] The slope of the total cost curves equals marginal cost. At the point of tangency LRATC = SATC.

LRATC = SATC and LRMC = SMC. If increasing returns to scale exist long run minimum will occur at a lower level of output than SRAC. then the SRAC curve would lie "wholly above" the LRAC and would not be tangent at any point. With fixed unit input costs. minimum short run average cost does not equal minimum long run average cost. For the short run curve the . if the production function has constant returns to scale. LRATC = SATC and LRMC = SMC.[11]:292-299 With fixed unit costs of inputs. if the production function has increasing returns to scale.[8]:229 [13]:186. This is because there are economies of scale that have not been exploited so in the long run a firm could always produce a quantity at a price lower than minimum short run aveage cost simply by using a larger plant. If the production process is experiencing decreasing or increasing. U-shaped curves Both the SRAC and LRAC curves are typically expressed as U-shaped.[14] With decreasing returns.[11]:292-299 Where LRTC = STC. The long run cost minimizing level of output may be different from minimum SATC. the shapes of the curves are not due to the same factors.[8]:211. Thus under constant returns to scale SRMC = LRMC = LRAC = SRAC .[11]:292-99 [13]:186 LRATC will always equal to or be less than SATC. LRATC = SATC and LRMC = SMC. 226 [13]:182. If not. For increasing returns to scale the point of tangency between the LRAC and the SRAc would have to occur at a level of output below level associated with the minimum of the SRAC curve. With fixed unit costs of inputs and decreasing returns the minimum of the SATC curve is to the left of the point of tangency between LRAC and SATC. then at the minimal level of the SATC curve we have SATC = LRATC = SMC = LRMC.           At the long run cost minimizing level of output LRTC = STC.[11]:292-299 Where LRTC = STC. the minimum of the SATC curve is to the right of the point of tangency between the LRAC and the SATC curves. a firm that is experiencing increasing (decreasing) returns to scale and is producing at its minimum SAC can always reduce average cost in the long run by expanding (reducing) the use of the fixed input. minimum SRAC occurs at a lower production level than minimum LRAC because a firm could reduce average costs by simply decreasing the size or its operations.187-188 However. These statements assume that the firm is using the optimal level of capital for the quantity produced.[15] Thus the points of tangency between the U-shaped LRAC curve and the minimum of the SRAC curve would coincide only with that portion of the LRAC curve exhibiting constant economies of scale.[1]:211 If production process is exhibiting constant returns to scale then minimum SRAC equals minimum long run average cost. With fixed unit costs of inputs.[11] :292-299. The minimum of a SRAC occurs when the slope is zero. The LRAC and SRAC intersect at their common minimum values.

The U-shaped cost curves form the foundation for the analysis of short-run. and marginal cost curves are directly or indirectly the result of increasing marginal returns for small quantities of output (production Stage I) followed by decreasing marginal returns for larger quantities of output (production Stage II).[2]:227 Increasing returns to the variable input at low levels of production also play a role.initial downward slope is largely due to declining average fixed costs. Although the average fixed cost curve is not U-shaped. which. then has rising cost at large quantities of output.[2]:227 U-SHAPED COST CURVES: The family of short-run cost curves consisting of average total cost. for firms that are perfect competitors in input markets. The decreasing marginal returns in Stage II result from the law of diminishing marginal returns.[13]:186 At low levels of production long run production functions generally exhibit increasing returns to scale. These three curves can provide all of the information needed about the cost side of a firm's operation. U-Shaped Cost Curves Bring on the Curves .[16] while the upward slope is due to diminishing marginal returns to the variable input. profit-maximizing production by a firm. all of which have U-shapes. average variable cost. average variable cost.[2]:227 the upward slope of the long run average cost function at higher levels of output is due to decreasing returns to scale at those output levels. means that the long run average cost is falling. reaches a minimum value. and marginal cost.[2]:227 With the long run curve the shape by definition reflects economies and diseconomies of scale. Each is U-shaped because it begins with relatively high but falling cost for small quantities of output. it is occasionally included with the other three just for sake of completeness. The U-shapes of the average total cost.

increasing marginal returns is in effect. is guided by increasing marginal returns for relatively small output quantities. then decreasing marginal returns for larger quantities. The marginal cost curve intersects the average variable cost curve at its minimum value.  Average Variable Cost: First. The marginal cost curve for Stuffed Amigos production is the only one of these three curves that is DIRECTLY affected by the law of diminishing marginal returns. . marginal cost is less than average variable cost. and turtles).The diagram to the right displays the three U-shaped cost curves--average total cost curve (ATC). marginal cost is greater than average variable cost.  The average variable cost curve reaches its minimum at 6 Stuffed Amigos. when average variable cost is declining (the average variable cost curve is negatively sloped). Up to a production of 4 Stuffed Amigos. average variable cost curve (AVC). In particular. From the 5th Stuffed Amigo on.5 Stuffed Amigos. the production of Wacky Willy Stuffed Amigos. decreasing marginal returns (and the law of diminishing marginal returns) takes over. armadillos. The Average-Marginal Relation The average total cost. and marginal cost curves depict the basic mathematical relation that exists between any average and the corresponding marginal. The U-shaped pattern for the marginal cost curve that results from increasing and decreasing marginal returns is then indirectly responsible for creating the U-shape of the average variable cost and average total cost curves. like other goods. And when average variable cost is rising (the average variable cost curve is positively sloped). average variable cost. note the relation between the average variable cost curve and the marginal cost curve. Consider a few reference points:  The marginal cost curve reaches its minimum value at 4 Stuffed Amigos. and marginal cost curve (MC)--for the production of Wacky Willy Stuffed Amigos (those cute and cuddly snakes. Moreover. All three curves presented in this diagram are Ushaped.  The average total cost curve reaches its minimum at 6.

What About Average Fixed Cost? Although the average fixed cost curve is not displayed in this exhibit. Total cost is quantity times average total cost. average total cost. The reason for the narrowing gap is that the difference between the two curves is average fixed cost. this diagram of the three U-shaped cost curves provides all of the information available about the cost incurred by a firm for short-run production. it is not really needed. And total fixed cost is quantity times average fixed cost. average fixed cost can be obtained. but narrows with greater production. the average-marginal relation is also seen with the average total cost curve. And What About the Totals? All total cost values--total cost. As such. average fixed cost can be derived from the average total cost and the average variable cost curves. The marginal cost curve intersects the average total cost curve at its minimum value. and total fixed cost--can also be derived from this diagram. then the total cost measures can be derived. and average fixed cost. Because average fixed cost declines with greater production. First. as well. (2) the marginal cost curve has a positive slope. so too does the gap between these curves. are known. While an average fixed cost curve is sometimes included in a diagram such as this one. which is average fixed cost. So long the average total cost and the average variable cost curves are available. note that the distance separating the average total cost curve and the average variable cost curve is relatively wide for small quantities of output. . When average total cost is rising (the average total cost curve is positively sloped). As such. Total variable cost is quantity times average variable cost. the marginal cost intersects the minimum of the average variable cost curve at 6 Stuffed Amigos. marginal cost is less than average total cost. Average Total Cost: Second. then rises a bit before intersecting the minimum of the average total cost curve at 6. When average total cost is declining (the average total cost curve is negatively sloped). If the output quantity. total variable cost.5 Stuffed Amigos. marginal cost is greater than average total cost. and (3) there is a gap between the two average curves. Note that the minimum values of the average total cost curve and the average variable cost curve occur at different quantities. As such. This results because: (1) marginal cost intersects each average curve at its minimum value. average fixed cost can be derived from this diagram by calculating the vertical distance between the average total cost and the average variable cost curves.

which is assigning probabilities to potential future outcomes. Or a meteor could crash through your ceiling and destroy your computer. Uncertainty is translated into the related notion of risk by assigning probabilities to the possibilities. but a computer-destroying meteor has a chance of only 0.000000001% chance of total planet destruction). however. such as stocks and bonds. And a dead car battery has a 2% probability. are based on uncertainty of the future. A lot could happen. While any number of events might occur in the future. especially information about the future. is not known. Any number of events might occur.UNCERTAINTY: The observation and recognition that information.00000000001%? . Almost anything is possible. Risk and uncertainty are important to financial markets. Risk. Not knowing what will happen is uncertainty. 99. Uncertainty is simply the observation that the future is unknown.999999999% chance of mud puddle stepping versus 0. Uncertainty versus Risk A concept related to uncertainty that is frequently (and erroneously) used synonymously is risk. The chance of a call from a vinyl siding telemarketer might be 20%. You might step in a puddle of mud on the way to class. both are not equally likely outcomes. different concepts. Or the battery in your car might go dead. Risk is the process of assigning probabilities to these alternatives (for example. For example. They are. And the probability of a meteor crashing through your ceiling and destroying your computer is only 0. Uncertainty means that people are ignorant about some things. An anthropology pop quiz might have a 10% chance of happening. A related concept is risk.00000000001%. That is uncertainty. Translating uncertainty into risk begs the question: How are these quantitative probabilities identified? How do you know that a ham-and-cheese lunch has a probability of 50%. in particular. in contrast. is assigning quantitative probabilities to the possibilities. While it is possible that you could either step in a mud puddle or your could cause total destruction of the planet. A wide range of future outcomes are possible (potentially infinite). Or you might receive an unsolicited telemarketing phone call for vinyl siding. uncertainty exists because which specific events will occur is unknown. You could eat a ham and swiss cheese sandwich for lunch. Or you might anger an intelligent extraterrestrial life form that retaliates by destroying all life on the planet. you might have a 50% probability of eating a ham and swiss cheese sandwich for lunch tomorrow. You don't know what will happen tomorrow. Uncertainty is a central component in the economic study of information. Or you could have a pop quiz in your anthropology class. and the differences are important. You just never know. The exchange of financial instruments. they lack information about the future. tempered with attempts to quantify the risk of different possibilities.

bonds. you guess. government policy makers. The probability of an anthropology quiz might be higher if you know that your instructor likes to give quizzes at the end of the week and tomorrow is Friday. Suppose. If your anthropology instructor has given 2 pop quizzes over the last 20 days. it just doesn't know which specific person it will be. In other cases the probabilities are based on historical records. .000. This transfer of risk is undertaken in exchange for a premium payment. If. You have a hunch. Financial Markets Risk and uncertainty are also key to financial markets. Insurance Uncertainty of the future and the quantification of this uncertainty as risk is fundamental to the provision of insurance. Financial markets exchange financial instruments or legal claims. for example. That is. the individual agrees to incur a small guaranteed loss (the premium) but avoids incurring a less likely but much larger loss. The key is that the insurance provider knows that 1 of the 100 customers will incur the $20. financial investors. and many others facing the uncertainty of future events.In some cases the probabilities are subjectively determined. The most common financial market is the stock market that exchanges corporate stock. and futures contracts. for example. the historical data is augmented with information about other cause-andeffect connections. The chance of receiving a telemarketing call might be lower that historical data suggests if you recently added your name to a "do not call" list. The insurance provider spreads this $20. Insurance companies assign the probability of having a car wreck. The insurance provider spreads this slight risk of a large expense for one person over a large group. Investors assign the probability of a stock price increasing. which are legal claims representing ownership of corporations. Insurance is a service that transfers the risk of large losses from an individual to a larger group. you have eaten a ham and cheese sandwich for lunch 15 out of the last 30 days. the vast majority who pay the premium but do not incur the expense. spend a great deal of time and effort working through historical data and cause-and-effect links to assign probabilities to the possibilities. but shifts the (slight) risk of a major expense associated with an accident to the insurance provider. Insurance companies. then the chance of doing so tomorrow is 50%. In still other cases.000 expense. It just "seems" like you have a 20% chance of receiving a telemarketing call for vinyl siding. That is. a person pays an automobile insurance premium each month (guaranteed). The larger group is typically represented by an insurance provider. that insurance is provided to 100 people and one member of this group is involved in an accident that incurs a cost of $20. such as stocks.000 expense over the 100 people by charging each a premium of $200. Policy makers assign the probability of having an economic contraction. For example. then you can calculate the probability of a pop quiz tomorrow at 10%.

If your information is better and the price does increase. The accuracy of the information plays a big part in who "wins" and "loses" in the financial markets. is uncertainty. then you win. you might be able to assign probabilities to alternative outcomes. Inc. Or perhaps you read that the economy will be prospering and with it the demand for company production will increase. . based on expectations that the company will be more profitable in the near future. the company has had positive profit three-fourths of the time and a loss only one-fourth of the time. However. While the future profitability of OmniConglomerate. you might be willing to buy a few shares of OmniConglomerate. For example. then you lose. The odds are three to one of a positive profit in the coming year. If the seller has better information and the price decreases. Inc. Perhaps because you heard that the company is on the verge of obtaining a lucrative government contract. Perhaps you know that over the past 20 years.Those who buy and sell legal claims do so with recognition that the future is uncertain. You might then adjust this probability with other information. they also attempt to transform this uncertainty into quantifiable risk.