THE CONSTANT COST FIRM

Let’s imagine a simple firm (business) whose costs we can describe with just two numbers:

Total Fixed Cost (TFC) and Variable Cost per unit (v or vcpu)

Variable Cost per unit will actually have a variety of names:

It can appear as v or vcpu as well asAVC (average variable cost) or MC (marginal cost)

THE CONSTANT COST FIRM

Total Fixed Costs (or just “Fixed Cost”) includes all the costs that must be paid regardless of how much the firm

produces. These costs are often called “overhead.”

Examples of fixed cost are rent and interest payments(i.e. the costs of land and capital)

For our example firm, let’s suppose these costs are $24,000 per month.

THE CONSTANT COST FIRM – Fixed Costs

We could now compute Average Fixed Cost, the portion of fixed cost attributable to each unit of output.

Using TFC = $24,000, if the firm produced 10 units in a month (Q = 10) then Average fixed cost is

AFC = $24,000÷10 units = $2,400 per unit

If the firm produced 100 units, then Average fixed cost is

AFC = $24,000÷100 units = $240 per unit

Average Fixed Costs (fixed cost per unit)

It is always true that as output rises, average fixed cost (AFC) decreases. See the following table. “Q” designates the output of the firm.

 Q AFC 

   

   

   

   

   

   

   

Let Total Fixed Cost (TFC) equal $24,000 per month. Compute AFC for each Q, then click for the correct answer. The formula is AFC = TFC ÷ Q

This is a “trick”. You can’t compute an average when Q is 0. (You’re not allowed to divide by zero.)###

100

0

240 24,000 ÷ 100 = $240 per unit

200 120 24,000 ÷ 200 = $120 per unit

300 80 24,000 ÷ 300 = $80 per unit

400 60 24,000 ÷ 400 = $60 per unit

500 48 24,000 ÷ 500 = $48 per unit

600 40 24,000 ÷ 600 = $40 per unit

You can see that as output (Q) gets larger, AFC gets smaller. We are “spreading” the overhead of $24,000 over more units of output, making each unit “carry” less of the fixed cost.

Now let’s graph the information from the previous table.

 Q AFC 

   

   

   

   

   

   

   

100

0

240

200 120

300 80

400 60

500 48

600 40

OK, we can’t graph this one! Average Fixed Cost

0

20

40

60

80

100

120

140

160

180

200

220

240

260

0 100 200 300 400 500 600 700

Q

$/Q

The point shows a quantity of 100 and a fixed cost per unit of $240.

A quantity of 200, AFC of 120

Q = 300, AFC = 80

And now connect the dots

First notice the labels on the axes.

The horizontal axis measures “Q” – the quantity of the firm’s output.

The vertical axis measures “$/Q” – dollars per unit.

This combination of axis labels – Q and $/Q -- will be very common.

We rarely need to use actual numbers. What we want is a basic picture of AFC.

$/Q

Q

Draw the axes

Label the axes

Draw the curve

Properties of the curve

1. Starts high and falls fast, but then almost levels off.

2. Never gets to zero. That is, it gets close to, but never reaches, the axes.

Label the curve

AFC

Learn to draw this picture!

Include all the labels every time.

AVERAGE FIXED COST (AFC)

Variable Cost per Unit

We looked at a firm’s fixed costs. The second type of cost is variable costs, those costs which change as the firm produces more or less.

The most common types of variable costs are wages and raw materials.

To keep our example very simple for the moment, we will assume that there is a given, constant variable cost per unit.

For our example let’s say that each unit of output costs $60 in variable cost of materials and labor.

Graphing variable cost per unit in this simple case (v = $60) ought to be pretty easy.

$/Q

Q

Draw the axes

Label the axesNote the same labels as we used before.

Draw the curve

Label the curve

Learn to draw this picture!

Include all the labels every time.

v60

Again, this curve will get many names: v, vcpu, AVC or MC

The flat line says that v is $60 at any level of output (Q).

$/Q

Q

v60

ATC is the sum of AFC and v. We add graphically by raising AFC by the amount of v.

Now let’s combine the two per-unit costs, fixed and variable, to get average total cost (ATC), which we could also just call “cost per unit.”

AFC

ATC

The distance is equal to v, so that

ATC = AFC + v.

Actually the picture we will want most shows only v and ATC. That is:

ATC

v

Q

$/Q

This will be an important picture. Learn to sketch it, including all the labels.

THAT’S ALL FOR NOW