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Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter Choice in a World of Scarcity , fixed costs are often sunk costs    that cannot be recouped. In thinking about what to do next, sunk costs should typically be ignored, since this spending has already been made and cannot be changed. However, variable costs can be changed, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.

Why are total cost and average cost not on the same graph?

Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. These costs are measured in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, they are measured as cost per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since they are measured in different units ($ versus $ per unit of output).

It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. But the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.

Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit    , also known as the firm’s profit margin . Expanding the equation for profit gives:

average profit = profit quantity produced = total revenue – total cost quantity produced = total revenue quantity produced total cost quantity produced = average revenue – average cost

But note that:

average revenue = price × quantity produced quantity produced = price

Thus:

average profit = price – average cost

This is the firm’s profit margin . This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative.

The marginal cost of producing an additional unit can be compared with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how profits would be affected by increasing or decreasing production.

A variety of cost patterns

The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an Internet company that provides medical advice to customers. Such a company might be paid by consumers directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.

For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine maintenance of the equipment, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.

Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.

Key concepts and summary

In a short-run perspective, a firm’s total costs can be divided into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.

Marginal cost is calculated by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.

Average total cost is calculated by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.

Average variable cost is calculated by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.

Problems

Return to [link] . What is the marginal gain in output from increasing the number of barbers from 4 to 5 and from 5 to 6? Does it continue the pattern of diminishing marginal returns?

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Compute the average total cost, average variable cost, and marginal cost of producing 60 and 72 haircuts. Draw the graph of the three curves between 60 and 72 haircuts.

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Questions & Answers

what is labour force
ademu Reply
Labour force is the number of people who are actively and presently working in a country to increase the availability of goods and services.
Mbye
It refers to the active population available for work at a going rate.
Daniel
The law of diminishing returns States that "all other things being equal as more and more of a variable factor(labour) is employed on a fixed factor (Land) ,marginal product initially increases reaches a maximum and there after diminishes or fall
samuel Reply
how does exceptional demand occur
Esther Reply
It occurs, due to certain reasons, but to make my answers brief. Exceptional demand occurs when our earnings change. As the law of demand says the higher the price the lower the demand. However no matter how high the price is the person will still purchase the good due to his level of income.
Mbye
opportunity cost definitions
Surur
What do you mean mean by opportunity cost definition?
Mbye
OK thanks for the answer
Esther
Opportunity cost, means, in order to get something, you sacrifice something
Taha
Opportunity cost simply means, sacrificing one commodity at the expense of another.
Mbye
A production manager should continue to use inputs until the Marginal Product (MP) reaches at zero. Justify this statement.
Newtan
What is the scale of preference
Mbye
Esther👌
TSEKO
The law of diminishing returns
Mbye
Apply, PoE, Process of elimination, the 1st stage of production is not correct for the producer to produce because he has the option to increase his production level, so, eliminate that. In third stage, its not rational to produce because, Total output declines. Hence, it is only in the second
Taha
Stage, that the producer produces, also because, it is at this stage that the total output is maximum.
Taha
Hence proved
Taha
A production manager should continue to use inputs until the Marginal Product (MP) reaches at zero. Justify this statement.
Newtan
plz help
Newtan
thanks
Surur
deference b/n aggregate demand and aggregate supply
Surur
ok a production manager should continue to use it inputs until MP reaches zero because at that stage it is called rational stage. And at this stage when a producer produce anything he/she will get more output, aside that too the Total product (TP) will also be at it maximum.
samuel
Exceptional demand occurs due to demand conditions, and when it does not obey the law of demand.
samuel
e
mukul
A production manager should continue to use inputs until the Marginal Product (MP) reaches at zero. Justify this statement.
Newtan Reply
anyone help me Please
Newtan
does the richest experience scarcity?
elan Reply
how do you master a subject
elan
Yes, this is due to the fact that human wants are unlimited in number how ever he has everything his heart desires, he still have dreams of owning/having something else of a great value.
Tusajigwe
that's true,thank you tusajigwe
elan
why firm maximize profits when MC=MR
Abel Reply
The night before an economic exam you decide to go for outing instead of staying at home and studying for your exam.you get 50 percent on your exam as compared with the 70 percent that you normally score.
Muhammad Reply
join me
Abel
why do banks charge fees and charges?
Shirley Reply
What is Labour
Angela Reply
the service provide by the labourer is termed as labour.
Prtj
Meaning of Standard of living
Fazrat Reply
pls what is the meaning of opportunity cost
Fazrat Reply
the cost of next forgone alternative is called opportunity cost. for example you have two choices, either work or study and you choose to study then the opportunity cost for study is the earnings which you can earn while opting job.
Prtj
so what if I choose work it is the same as study
Fazrat
if you choose to work, then the cost of study is the opportunity cost for work
Prtj
ohk tnx
Fazrat
welcome. much love .
Prtj
Hi
Frank
hi Frank
Prtj
what is production
Frank
the output made by firm or companies are called production. however production can be of tengible goods or it can be of intengible.
Prtj
Thanks
Frank
welcome Frank.
Prtj
how can inflation be defined
Mboko Reply
rise in general price level is called inflation.
Fardin
when the price of goods and services rise, the cost of living also increases. basically the increase in general price level is call inflation
Khushtar
when demand increase and supply decrease .leads to fall of quality and volume index's leads to inflation .
Khaja
inflation is a monitry policy that leads to continues increase in price of commodity in a geographical location with some period of time
Osola
why firm maximize profits when MC=MR
Abel
inflation can be define as the persistent increase in price of a commodity
Joseph
what is economic
Enock Reply
economics is a science under which we study all those human activities which is related to scarcity with unlimited wants. By proff. Robbins .
Vibhu
it is a social science
ashiru
what is the difference between macro economic and micro economic
Bubu
Economic is a social science which studies human behaviour in relation to ends and scares means which have alternative uses
Nana
Economic is a social science that studies individuals, busnisses,governments, and deal deal with the entire society as a scarcity.
Mo
what is the differences between ends and wants?
Richard
Economics is a social science which studies human behavior in relationship to ends and scares means which have alternative uses
Musu
what is the differences between ends and scarce
Albert
Ends is considered as goals,aims, objectives,want among others whereas scarce is the insufficient of resources to satisfy the needs of individual,firm,and state
Suzana
Economic is a science which study human behavior as a relationship between ends and scarce means which has alternative uses
Suzana
macroeconomics is the study of the economy as a whole while microeconomics is the study of individual consumers and business film.
nicholas
Economic is a social science which studies human behavior in relation to ends and scares means which have scares means which have alternative uses.
Awuah
what is the indicator of economics development
Bibu Reply
how can you answer economic development
Mankaa Reply
how
Fatema
Two things, first economic growth, just takes into account the increase in per capita income... Which is absolutely vague, important, but vague.On the other hand, Economic development, is a much more wider term. Visit my blog to know more about the differences, ***thetheoryofeconomics.blogspot.in
Taha

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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