Question

Changes in the price of key commodities have a significant impact on a company's bottom line. For virtually all companies, the price of energy is a substantial portion of their costs. In addition, many industries-such as those that produce beef, chicken, high-fructose corn syrup and ethanol-are highly dependent on the price of corn. In particular, corn has seen a significant increase in price. a. Explain how the cost of energy can be both a fixed cost and a variable cost for a company. b. Suppose energy is a fixed cost and energy prices rise. What happens to the company's average total cost curve? What happens to its marginal cost curve? Illustrate your answer with a diagram. c. Explain why the cost of corn is a variable cost but not a fixed cost for an ethanol producer. d. When the cost of corn goes up, what happens to the average total cost curve of an ethanol producer? What happens to its marginal cost curve? Illustrate your answer with a diagram.

Short answer

Answer: If energy is a fixed cost and energy prices increase, the company's average total cost (ATC) will increase, causing the ATC curve to shift upward. However, the marginal cost (MC) curve will remain unchanged, as an increase in fixed costs does not affect the cost associated with producing one more unit of output.

Step-by-step solution

a. Cost of Energy as Fixed and Variable Cost

Energy costs can be both fixed and variable costs for a company. Fixed costs are expenses that remain constant regardless of the level of production or the number of goods produced. In some cases, a company may have energy costs that don't change with the level of production, such as the electricity cost for maintaining the office lights and air-conditioning. These costs are considered fixed because they don't vary with the level of production. On the other hand, variable costs are expenses that increase or decrease depending on production levels. Energy costs can also be variable when they depend on the level of production or usage of machinery. For example, the electricity consumed in the manufacturing process, or the fuel required for vehicles directly involved in the production process, will vary with the production level. In these cases, energy costs become variable.

b. Impact of Rising Energy Prices on Average Total Cost and Marginal Cost Curves

Suppose energy is a fixed cost for a company, and energy prices rise. Since fixed costs increase, the company's average total cost (ATC) will also increase. The ATC curve will shift upward, reflecting the higher fixed costs. The marginal cost (MC) curve, however, will remain unchanged. This is because an increase in fixed costs does not affect the cost associated with producing one more unit of output. To illustrate this, we can draw an ATC curve and an MC curve. Before the increase in energy prices, the ATC curve is lower on the vertical axis. After the energy prices rise, the ATC curve shifts upward, indicating an increase in fixed costs. The MC curve remains unchanged.

c. Cost of Corn as a Variable Cost for an Ethanol Producer

The cost of corn for an ethanol producer is dependent on the amount of corn used in the production process. As the level of production increases, the ethanol producer needs more corn as an input, leading to higher total costs. Since the cost of corn changes with the level of production, it is considered a variable cost and not a fixed cost. Fixed costs remain constant, regardless of the production level.

d. Impact of Increasing Corn Costs on Average Total Cost and Marginal Cost Curve

When the cost of corn goes up, the ethanol producer's total variable costs increase, affecting both the average total cost curve and the marginal cost curve. As the price of corn rises, the cost of producing each additional unit also increases, leading to a higher marginal cost. Consequently, the MC curve shifts upward. The average total cost (ATC) curve is affected since the variable cost component increases. The ATC includes both fixed and variable costs, and an increase in corn prices will cause an increase in the variable costs, resulting in an upward shift of the ATC curve. To illustrate this, we can draw an ATC curve and an MC curve. Before the increase in corn prices, both curves are lower on the vertical axis. After the corn prices rise, both the ATC curve and the MC curve shift upward, indicating an increase in variable costs.

Key concepts

Fixed Costs

Fixed costs are those expenses that remain constant regardless of the level of production or the number of goods produced. They are expenses that a company must pay even if no goods are produced. For example, if a company owns a factory, the rent for this factory is a fixed cost, simply because it's incurred whether production is high or low.
Energy costs can sometimes be fixed, especially in the context of running facilities that need constant electricity or uniforms. These basic operational costs, like lighting or HVAC systems, remain unchanged whether a single product is made or thousands. Understanding fixed costs helps companies budget for regular expenses and forecast long-term financial requirements.

Variable Costs

Variable costs, unlike fixed costs, fluctuate with the level of production. The more you produce, the higher these costs get. They are tied directly to the level of activity.
For instance, in an ethanol production company, the cost of corn serves as a variable cost. As the firm's production scales up, more corn is required, thus increasing the total variable cost proportionately. Similarly, the use of energy as a variable cost can be seen in sectors demanding higher power consumption as production ramps up. Variable costs are essential for businesses in tracking profit margins and making key operational decisions.

Average Total Cost Curve

The average total cost (ATC) curve exhibits the average cost per unit of output, calculated by dividing total costs by the quantity of output produced. It includes both fixed and variable costs.
When fixed costs, like energy, increase, they affect the ATC curve by shifting it upwards, as each unit now bears a higher cost. However, this type of increase does not affect the shape of the curve materially, only its position. It's crucial for businesses to monitor the ATC curve to ensure pricing strategies cover costs and generate profit.
In industries heavily reliant on commodities like corn, any price hike in these inputs will likewise shift the ATC curve upward, reflecting the added production expense. This visualization assists businesses in planning their pricing adjustments in response to fluctuations in input costs.

Marginal Cost Curve

The marginal cost (MC) curve is a graphical representation showing the cost of producing one additional unit of output. This is key in deciding how much to produce, as it helps determine the most profitable production level. When variable costs increase, like a rise in corn prices for an ethanol producer, the MC curve shifts upward, reflecting the higher costs per additional unit.
Interestingly, if fixed costs increase (say, due to a higher energy price not linked to production), the MC curve remains unchanged because these costs do not impact the production of extra units. In essence, changes in fixed costs only affect total costs and not the marginal aspects. Firms rely on the marginal cost curve to make informed decisions about scaling production and maintaining efficiency.