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Formula: TC = TFC + TVC Where: TC = Total cost. TFC = Total fixed cost. TVC = Total variable cost.
Explanation:
Short run costs of a firm is now explained with the help of a schedule and diagrams.
Schedule:
(in Dollars) Units of Output (in Hundred) 0 1 2 3 4 5 6 7 Total Fixed Cost 1000 1000 1000 1000 1000 1000 1000 1000 Total Variable Cost 0 60 100 150 200 400 700 1100 Total Cost 1000 1060 1100 1150 1200 1400 1700 2100
The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at $1000/- regardless of the level of output. The column 3 indicates variable cost which is associated with the level of output. Total variable cost is zero when production is zero. Total variable cost increases with the increase in output. The variable does not increase by the same amount for each increase in output. Initially the variable cost increases by a smaller amount up to 3rd unit of output and after which it increases by larger amounts. Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level of output. The rise in total cost is more sharp after the 4th level of output. The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be illustrated graphically.
In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of output. It remains the same even if the firm's output is zero.
In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of output. It starts from the origin. Then increases at a diminishing rate up to the 4th units of output. It then begins to rise at an increasing rate.
In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at various levels of output has nearly the same shape. The difference between the two is by only a fixed amount of $1,000. The total variable cost curve and the total cost curve begin to rise more rapidly as production is increased. The reason for this is that after a certain output, the business has passed its most efficient use of its fixed costs machinery, building etc., and its diminishing return begins to set in.
Average Cost:
Definition and Explanation:
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in knowing the cost per unit of the product. The unit cost figures can be derived from the total fixed cost, total variable cost and total cost by dividing each of them with corresponding output.
Types/Classifications:
(1) Average Fixed Cost (AFC):
Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by dividing the total fixed cost by the corresponding output.
Formula:
Diagram/Curve:
The concept of average fixed cost can be explained with the help of the curve, in the diagram (13.4) the average fixed cost curve gradually falls from left to right showing the level of output. The larger the level of output, the lower is the average fixed cost and smaller the level of output, the greater is the average fixed cost. The AFC never becomes zero.
For instance, the total variable cost for producing 100 meters of cloth is $800, the average variable cost will be $8 per meter.
Formula:
AVC = TVC (Q)
Diagram/Curve:
The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows that when the output is increased, there is a steady fall in the average variable cost due to increasing returns to variable factor. It is minimum when 500 meters of doth are produced. When production is increased to 600 meters, of cloth or more, the average variable cost begins to increase due to diminishing returns to the variable factor.
Formula:
ATC = Total Cost (TC) Output (Q)
Diagram/Curve:
The average total cost is represented here by a shaped curve in Fig. (13.6). The average total cost curve is also like a U-shaped curve. It shows that as production increases from 100 meters to 200 meters of cloth, the cost falls rapidly, reaches a minimum but then with higher level of output, the average fixed cost begins to increase.
Diagram/Figure:
In the diagram 13.7 given above, there are five alternative scales of plant SAC1 SAC2, SAC3, SAC4and, SAC5. In the long run, the firm will operate the scale of plant which is most profitable to it. For example, if the anticipated rate of output is 200 units per unit of time, the firm will choose the smallest plant It will build the scale of plant given by SAC1 and operate it at point A. This is because of the fact that at the output of 200 units, the cost per unit is lowest with the plant size 1 which is the smallest of all the four plants. In case, the volume of sales expands to 400, units, the size of the plant will be increased and the desired output will be attained by the scale of plant represented by SAC2 at point B, If the anticipated output rate is 600 units, the firm will build the size of plant given by SAC3 and operate it at point C where the average cost is $26 and also the lowest The optimum output of the firm is obtained at point C on the medium size plant SAC3.
If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant given by SAC5 and operate it at point E. If we draw a tangent to each of the short run cost curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile short run cost curves. Mathematically expressed, the long-run average cost curve is the envelope of the SAC curves. In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the minimum cost at which optimum output OM can be, obtained. .
Example:
For example, the total cost of producing one pen is $5 and the total cost of producing two pens is $9, then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4). The marginal cost of the second unit is the difference between the total cost of the second unit and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference between the total cost of the 6th unit and the total cost of the, 5th unit and so forth. Marginal Cost is governed only by variable cost which changes with changes in output. Marginal cost which is really an incremental cost can be expressed in symbols.
Formula:
Marginal Cost = Change in Total Cost = TC Change in Output q The readers can easily understand from the table given below as to how the marginal cost is computed:
Schedule:
Units of Output 1 2 3 4 5 6 Total Cost (Dollars) 5 9 12 16 21 29 Marginal Cost (Dollars) 5 4 3 4 5 8
Graph/Diagram:
MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases sharply with smaller Q output and reaches a minimum. As production is expanded to a higher level, it begins to rise at a rapid rate.
It is clear from the diagram (13.9), that the long run marginal cost curve and the long run average total cost curve show the same behavior as the short run marginal cost curve express with the short run
average total cost curve. So long as the average cost curve is falling with the increase in output, the marginal cost curve lies below the average cost curve. When average total cost curve begins to rise, marginal cost curve also rises, passes through the minimum point of the average cost and then rises. The only difference between the short run and long run marginal cost and average cost is that in the short run, the fall and rise of curves LRMC is sharp. Whereas In the long run, the cost curves falls and rises steadily.
Relation of Average Variable Cost and Average Total Cost to Marginal Cost:
Before we explain, the relation of average variable cost (AVC) and average total cost (ATC) to marginal cost (MC), it seems necessary that the various types of costs and their relationship should be shown in the form of a table. This is illustrated in the table below:
Schedule:
Units of Total Fixed Output Cost (TFC) ($) 1 30 2 30 3 30 4 30 5 30 6 30 7 30 8 30 9 30 10 30 11 30 12 30 13 30 14 30 15 30 16 30 Total Variable Cost (TVC) ($) 15 16.9 18.4 19.4 20 22 25 30 36 43 60 90 125 165 210 270 Average Total Cost (ATC) ($) 45 23.4 16.1 12.3 10 8.7 7.8 7.5 7.3 7.3 8.2 10 11.9 13.9 16 18.7 Average Average Marginal Cost Fixed Cost Variable Cost (MC) (AFC) (AVC) ($) ($) ($) 30 15 15 15 8.4 1.9 10.1 6.1 1.5 7.5 4.8 1 6 4.0 0.6 5 3.7 2 4.3 3.6 3 3.7 3.7 5 3.3 4 6 3 4.3 7 2.7 5.5 17 2.5 7.5 30 2.3 9.6 35 2.1 11.8 40 2 14.8 45 1.9 16.7 60
From the table, the reader can understand the relation of various types of costs to each other. We take, first of all, the relation of average total cost to marginal cost. As production increases, the average total cost and the marginal cost both begin to decrease. The average total cost goes on decreasing up to the 9th unit and then after 10, it begins to rise. The marginal cost goes on falling up to 5th unit and then it begins to increase. So long as the average total cost does not rise, the marginal cost remains below it. When average total cost begins to increase, toe marginal cost rises more than the average total cost. Summing Up:
(1) When average cost is falling, the marginal cost is always lower than the average cost. (2) When average cost is rising, marginal cost lies above AC and rises faster than AC. (3) The marginal cost curve must cut the average cost curve at the minimum point of AC.
Diagram/Figure:
In the diagram (13.10) AFC, AVC, ATC and MC curves are shown. Here, units of production are measured along OX and cost along OY. ATC and AVC both fall in the beginning, reach a minimum point and then begin to rise. So is the case with the marginal cost curve. It first falls and then after rising, sharply crosses through the lowest point of average variable cost and average total cost and rises.