Source: Image of Cost Curves Graph created by Kate Eskra
Hi. Welcome to Economics. This is Kate. This tutorial is on Cost: Total, Marginal and Average. As always my key terms are in red and my examples are in green.
In this tutorial we will be looking at different ways of looking at cost, in total, marginally and then on average. When I show you on a graph, you'll see the relationship between these curves. And we'll be talking about how it is that businesses actually use these costs to make production decisions.
We know that the point of owning a business is to make a profit. We also know that profit equals our revenues or sales minus what it cost us to produce them. I just wanted to remind you that for this tutorial here's where we're focusing. We're not on the revenue side of things here. We're on the cost side of it.
Let's start with an easy one, total cost. Total cost is just all of our costs. And there's only two kinds of costs, costs that are variable and costs that are fixed. So if we add them together, total cost equals fixed plus variable. And I just made up some numbers here. Notice, these are production levels. So this is the quantity that we're producing. Notice that fixed costs are the same regardless of how much we're producing and that's what fixed costs are. Even when we produce nothing we still have a fixed cost. A good example of a fixed cost is rent. Even if you produce nothing you can't get out of your lease. You still have to pay it.
Now we have variable costs. Variable costs do rise as we decide to produce more, hence, they vary with production. If we just add these together, that's how we get total cost. So we just add horizontally here, fixed plus variable to get our total cost.
Let's talk about average cost now. Average. If we were talking about average total cost it would be total cost divided by quantity. Another way that we could do it is if we had our average fixed cost and our average variable cost we could add them together to get average total cost since fixed plus variable equal total.
How you would get average fixed cost is you would, instead of taking total cost and dividing by quantity you would take your fixed cost and divide by quantity. If you were looking for average variable cost, you would take your variable cost figures here and divide by the quantity. But here we're talking about average total cost. So what I did to get all of these numbers is I took my total cost then I divided by the quantity each time.
So what does this even tell us though? So let's say, maybe we're producing five units, so at five units this tells us that on average each one of those five is costing us $37 per unit. Notice that it changes depending on how much were producing. Here, it falls at first. So as we produce a little bit more we are spreading out our cost. The cost is falling. But at some point it rises. And that's pretty typical, that at some point it will fall and at some point it will begin to rise again.
In average cost, that's what average costs help us do. It helps a firm compare costs at various production levels and then make decisions. So for an average total cost curve if we find that price is just enough to cover our average total cost then the firm's breaking even because they're just covering everything that it took to produce that level, that many units on average. Anything better than that. So if the price is actually covering over and above our average total cost that means that per unit we're taking in in revenue more than it's costing us to produce. That would mean we're making a profit. And I'll show you this again on a graph in a couple slides.
Our average total cost is going to help us with long-run decisions because, obviously, we know that we want to make a profit. So we're very concerned about this. But sometimes in the short run a firm is just trying to do the best that they can. They may not always be making a profit in the short-run. So, instead, the question will become, well, can I at least cover my average variable cost per unit? So if they can at least cover their average variable cost that means that they can at least pay their employees to come in, they can at least pay for all the raw materials.
If their price is over and above that, and can at least cover those variable expenses, than they should probably consider continuing to produce even if it's not at a profit, in the short run. Because they can put some of those expenses towards their overhead, like rent. That's why the supply curve is our marginal cost curve from above the point where price is over and above our AVC. If price can't cover our variable expenses then that means we're paying more for our workers to come in and our raw materials. Then we're not even able to cover those things. So we should really contemplate shutting down at that point, if price dips below average variable cost.
Let's talk about marginal cost now. Marginal, remember, means additional. So this is the additional cost incurred when producing one additional product. Here we look incrementally. Marginal cost is the change in total cost divided by the change in quantity. Here our change in quantity is just one each time so it's just the change in total cost. And that's exactly what I did here. If you look from here, to here, is a change of 20. So our marginal cost from going from one unit to two units of production is an additional 20. From here to here, and it's an additional $10.
Notice how marginal costs are going to change. Their not constant over this example. They fall at first and then they increase. Generally, the assumption is going to be that an industry will have decreasing cost along some part of its production capacity. Here, that's where this is the case.
What do these changing marginal costs tell us? Well, in increasing cost industries, that's where average total cost increases as they produce more. And this marginal cost will be increasing if it's an increasing cost industry.
In a decreasing cost industry, our average total cost will fall as we produce more. I think I mentioned that a few slides ago. Where, as we produce more, we can spread out some of our upfront costs and so our average costs will begin to fall. That's known as economies of scale, meaning it's economical to get bigger, to produce more. Here, our marginal costs would be decreasing.
Then we have constant cost industries where marginal costs would remain the same regardless of production level. Here's what it looks like on a graph. You might want to flip back and forth between my previous slides where I had the numbers. If you're a visual person and you like to see the numbers.
But remember, marginal cost did fall for a short period of time and then it rose. Our average total cost when I showed you the numbers, fell, and then rose. Average variable cost would do the same thing if you went and calculated them. That's how these curves look.
Notice the relationship between the marginal and both average curves wherever the marginal lies below the average. So from the left of this green dot here the marginal is below the average. Notice how because it's below, it's pulling the average down. An analogy I like to use is a sports analogy. Let's say, a quarterback is averaging two touchdown passes per game. If they have a really bad game and their marginal or additional, the next game, is worse than that, won't it pull his average down? That's what's happening here.
As soon as the marginal jumps up above the average, which is to the right of this green dot, now the athlete-- let's say his next game, his marginal performance he throws five touchdown passes. That's going to pull his average up. And here where the marginal jumps up above the average it's going to pull the average back up. It has to. That's just the law of averages. So the marginal cost must intersect an average at its minimum point. And that's what's going on here.
When a firm is able to produce where price or where the demand curve just equals average total cost-- I mentioned this before. That's known as the break even point. So here, visually on a graph, is where that break even is. If price is up above this that means they are over and above. Their generating price is more than covering all their costs so their profitable.
When a firm can't even cover its variable costs that's where they need to consider shutting down. And so that's what this point corresponds to, the shutdown price, or shutdown point. So the short run supply curve in this example would be at the marginal cost curve above this. Because they would only produce when price is above that point.
So in this tutorial we looked at different costs, total, marginal and average. We talked about the relationship between these curves. How marginals will always intersect the average total cost and average variable cost curves at their minimum. And hopefully you got to see how a firm uses these costs to make production decisions. So it shows us our break even point, where we're profitable, and where in fact we should consider shutting down.
Thank you so much for listening. Have a great day.
Variable plus fixed costs.
Additional cost incurred when producing one additional product.
Total cost divided by quantity.