No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 166 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 ($2 each). The marginal cost curve tends to slope downward initially as the benefits of the division of labor and gains from specialization lead to increased production efficiency and thus reduced marginal costs. Eventually, however, production will hit diminishing returns and the marginal cost curve will begin sloping upward. Average fixed costs (AFC) simply takes the total fixed costs (TFC) and divides that total by the quantity produced (i.e., AFC = TFC/Q). As seen in Figure 7.8 , the result is a steadily decreasing AFC as the fixed cost is spread out over more and more items produced. Think of it this way: your local amusement park may decide to add a new roller coaster. The purchase price of the roller coaster is fixed, and as the theme park sells more and more tickets, the cost of that roller coaster per ticket goes down as the fixed cost is spread over more riders. Average variable costs (AVC) and average total costs (ATC) are calculated similarly; the total costs are divided by the quantity produced. The distance between the AVC and ATC curve is equal to the AFC as seen by the blue arrows in Figure 7.8 . Average total (unit) costs: the average cost of one unit of output. It is calculated by dividing total costs by the quantity produced: ATC = TC/Q. Figure 7.8, Average Cost Curves. The Average Total Cost curve is U-shaped due to 1) spreading fixed costs over a larger quantity, and ultimately, 2) diminishing returns. Average Variable Cost and Marginal Cost curves reflect the gains from specialization where they slope down and then diminishing returns which drives the curves upward. The MC curve must intersect the ATC and AVC curves at their minimum. Output (Q) Average Cost Curves Costs ($) MC ATC AVC AFC Marginal cost: the cost to produce the next unit of output. Average (fixed, variable, or total) costs: the average (fixed, variable, or total) cost of one unit of output. It is calculated by dividing the fixed, variable, or total costs by the quantity produced: AFC = FC/Q, AVC = VC/Q, and ATC = TC/Q.