Question

1What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs?

Short answer

The shapes of different cost curves are as follows: - Fixed costs curve: a straight horizontal line, as it remains constant regardless of the output level. - Variable costs curve: upward sloping, as variable costs increase with higher output levels. - Marginal costs curve: U-shaped, as it initially decreases due to economies of scale, hits a minimum point, and then increases due to diseconomies of scale. - Average total costs curve: U-shaped and smoother than the marginal cost curve, combining both fixed and variable costs. - Average variable costs curve: U-shaped like the marginal cost curve, but generally lower due to the absence of fixed costs.

Step-by-step solution

Understanding and drawing the Fixed Costs Curve

The fixed costs are costs that do not change with the level of output. These are costs that a firm must pay whether they are producing or not, like rent or salaries. Therefore, the fixed costs curve is a straight horizontal line. It does not change with the level of output.

Understanding and drawing the Variable Costs Curve

The variable costs are costs that vary directly with the level of output. These are costs related to production, like cost of raw materials. As output increases, more raw materials (for example) are needed, so variable costs increase. Thereby, the variable costs curve slopes upwards as output increases.

Understanding and drawing the Marginal Costs Curve

Marginal cost is the cost of producing one more unit of output. It initially decreases with an increase in output, reaches a minimum and then starts increasing. This is due to economies of scale at lower output levels and diseconomies of scale at higher output levels. Thus, the marginal cost curve is U-shaped.

Understanding and drawing the Average Total Costs Curve

The average total cost is the total cost divided by the quantity of output produced. It includes both fixed and variable costs. It has a similar trend to the marginal cost curve, with a U-shape, but is smoother due to the averaging effect of all costs. It is always above the average variable cost curve.

Understanding and drawing the Average Variable Costs Curve

The average variable cost is the variable cost divided by the quantity of output produced. It excludes fixed costs. This curve follows a similar shape to the marginal cost curve because as more units are produced the variable cost per unit can decrease due to economies of scale. It then starts to rise after a certain point due to diseconomies of scale. Thus, the average variable cost curve is U-shaped and generally lower than the average total cost curve.

Key concepts

Fixed Costs

Fixed costs represent the expenses that a business incurs regardless of the production level. These costs are 'fixed' over a specified period and are independent of output volume. Examples include rent, insurance, and full-time salaries. When visualized on a graph, the fixed costs curve appears as a constant horizontal line, illustrating that no matter the quantity produced, fixed costs remain constant. Particularly for students trying to grasp this concept, it's crucial to understand that these costs are inevitable, even if production temporarily halts.

Variable Costs

Variable costs, in contrast to fixed costs, fluctuate with the level of production. The more you produce, the higher the variable costs. These include costs of materials, labor hours, and utilities that are tied to the production volume. Consequently, the variable costs curve slopes upwards with increased output, reflecting the proportionality between production quantity and associated costs. It's vital for students to recognize that managing variable costs effectively can lead to economies of scale, where costs per unit can decline as production increases.

Marginal Costs

Marginal cost is defined as the cost of producing one additional unit of a good or service. This concept is pivotal when decisions need to be made about increasing production. The marginal cost curve typically has a U-shape, representing an initial decrease in marginal costs due to efficiency gains (economies of scale) as production ramps up, followed by an increase as production continues to rise, leading to inefficiencies (diseconomies of scale). Understanding the behavior of marginal costs is important for optimizing production levels to achieve cost-effectiveness.

Average Total Costs

Average total cost (ATC) is simply the total cost (fixed plus variable) divided by the number of units produced, giving us the cost on a per-unit basis. The ATC curve helps businesses determine the most efficient scale of operation. Like the marginal cost curve, the ATC curve is U-shaped because it captures the effects of spreading fixed costs over more units (which lowers ATC) and the variable costs increasing at higher production levels. Getting familiar with the ATC curve enables students to understand how businesses can achieve the lowest possible cost per unit through scale optimization.

Average Variable Costs

Average variable cost (AVC) is calculated by dividing variable costs by the quantity of output. Since it involves only variable costs, it excludes any consideration of fixed costs. The AVC curve also takes on a U-shaped form but generally remains below the ATC curve since ATC includes fixed costs. Students should pay particular attention to how AVC reflects the behavior of variable costs as production scales and should use this understanding to distinguish it from the average total costs of a product.