COSTS & MARKET STRUCTURE

Costs in the Short Run

The short run is a period of time for which two conditions hold:
1. The firm is operating under a fixed scale (fixed factor) of production, and 2. Firms can neither enter nor exit an industry.

In the short run, all firms have costs that they must bear regardless of their output. These kinds of costs are called fixed costs.

Costs in the Short Run

Fixed cost is any cost that does not depend on the firm s level of output. These costs are incurred even if the firm is producing nothing. Variable cost is a cost that depends on the level of production chosen.

Total Cost = Total Fixed + Total Variable Cost Cost

TC ! TFC  TVC

Fixed Costs
Firms have no control over fixed costs in the short run. For this reason, fixed costs are sometimes called sunk costs. Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units of output (q):
TFC AFC ! q

Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm

(1) q 0 1 2 3 4 5 (2) TFC $1,000 1,000 1,000 1,000 1,000 1,000 (3) AFC (TFC/q) $  1,000 500 333 250 200

AFC falls as output rises; a phenomenon sometimes called spreading overhead.

Variable Costs
The total variable cost curve is a graph that shows the relationship between total variable cost and the level of a firm s output.
The total variable cost is derived from production requirements and input prices.

Marginal Cost
Marginal cost (MC) is the increase in total cost that results from producing one more unit of output. Marginal cost reflects changes in variable costs.

(TC (TFC (TVC MC ! !  (Q (Q (Q

Derivation of Marginal Cost from Total Variable Cost

UNITS OF OUTPUT 0 1 2 3 TOTAL VARIABLE COSTS ($) 0 10 18 24 MARGINAL COSTS ($) 0 10 8 6

Marginal cost measures the additional cost of inputs required to produce each successive unit of output.

The Shape of the Marginal Cost Curve in the Short Run

The fact that in the short run every firm is constrained by some fixed input means that:
1. The firm faces diminishing returns to variable inputs, and 2. The firm has limited capacity to produce output.

As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output.

The Shape of the Marginal Cost Curve in the Short Run

Marginal costs ultimately increase with output in the short run.

Graphing Total Variable Costs and Marginal Costs

Total variable costs always increase with output. The marginal cost curve shows how total variable cost changes with single unit increases in total output.
Below 100 units of output, TVC increases at a decreasing rate. rate. Beyond 100 units of output, TVC increases at an increasing rate.

Average Variable Cost

Average variable cost (AVC) is the total variable cost divided by the number of units of output. Marginal cost is the cost of one additional unit. Average variable cost is the average variable cost per unit of all the units being produced. Average variable cost follows marginal cost, but lags behind.

Relationship Between Average Variable Cost and Marginal Cost

When marginal cost is below average cost, average cost is declining.
When marginal cost is above average cost, average cost is increasing. Rising marginal cost intersects average variable cost at the minimum point of AVC. AVC.

At 200 units of output, AVC is minimum, and MC = AVC. AVC.

Short-Run Costs of a Hypothetical Firm

(1) q 0 1 2 3 4 5    500 $ (2) TVC 0 10 18 24 32 42    8,000 (3) MC (( TVC) TVC) $  10 8 6 8 10    20 (4) AVC (TVC/q) TVC/q) $  10 9 8 8 8.4    16 (5) TFC $ 1,000 1,000 1,000 1,000 1,000 1,000    1,000 (6) TC (TVC + TFC) TFC) $ 1,000 1,010 1,018 1,024 1,032 1,042    9,000 (7) AFC (TFC/q) TFC/ $  1,000 500 333 250 200    2 (8) ATC (TC/q or AFC + AVC) $  1,010 509 341 258 208.4    18

Total Costs
Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost.
Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC. TFC.

TC ! TFC  TVC

Average Total Cost

Average total cost (ATC) is total cost divided by the number of units of output (q).

ATC ! AFC  AVC

TC TFC TVC ATC ! !  q q q
Because AFC falls with output, an everever-declining amount is added to AVC. AVC.

Relationship Between Average Total Cost and Marginal Cost

If marginal cost is below average total cost, average total cost will decline toward marginal cost. If marginal cost is above average total cost, average total cost will increase. Marginal cost intersects average total cost and average variable cost curves at their minimum points.

Output Decisions: Revenues, Costs, and Profit Maximization

In the short run, a competitive firm faces a demand curve that is simply a horizontal line at the market equilibrium price.

Total Revenue (TR) and Marginal Revenue (MR)

Total revenue (TR) is the total amount that a firm takes in from the sale of its output.

TR ! P v q
Marginal revenue (MR) is the additional revenue that a firm takes in when it increases output by one additional unit. In perfect competition, P = MR. MR.

(TR P( (q ) MR ! !P ! (q (q

Comparing Costs and Revenues to Maximize Profit

The profit-maximizing level of output for all firms is the output level where MR = MC. In perfect competition, MR = P, therefore, the profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost. The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost.

Profit Analysis for a Simple Firm

(1) q 0 1 2 3 4 5 6 (2) TFC $ 10 10 10 10 10 10 10 (3) TVC $ 0 10 15 20 30 50 80 (4) MC $  10 5 5 10 20 30 (5) P = MR $ 15 15 15 15 15 15 15 (6) TR (P x q) $ 0 15 30 45 60 75 90 (7) TC (TFC + TVC) TVC) $ 10 20 25 30 40 60 90 (8) PROFIT (TR  TC) TC) $ -10 -5 5 15 20 15 0

The Short-Run Supply Curve

At any market price, the marginal cost curve shows the output level that maximizes profit. Thus, the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm s short-run supply curve.