Chapter 20 Cost
Sales - Costs = Profit
Sales - Costs = Profit
Total cost is the sum of fixed and variable costs.
TC = FC + VC
Total Revenue (TR) - Total Cost (TC)= Profit (the bottom line)
Total Revenue (TR) - Total Cost (TC)= Profit (the bottom line)
Total Revenue - Total Cost = Profit
Total Revenue - Total Cost = Profit
MC is the cost of producing one additional unit of output.
MC = change in TC ÷ change in Q
The firm can make the same stay in business or go out of business decisions on the basis of price and average total cost.
Recall, a firm will go out of business if TC > TR , or A firm will go out of business if TC > P x Q
short run
As long as there are any fixed costs, we are in the short run. The present time is always the short run. The short run is the length of time it takes all fixed costs to become variable costs. In other words, the length of time it takes to eliminate all fixed costs. A steel firm might need 10 years to pay off such fixed costs as interest and rent. Even a grocery store would need a few weeks or months to sublet the store and discharge its other obligations.
The Decision to Stay In or Go Out of Business: The Long Run
In the long run, firms must decide to stay in business or go out of business. The firm will stay in business if the total revenue is greater than total cost. The firm will go out of business if the total cost exceeds total revenue. Going out of business means that all fixed cost obligations are met. Does everybody who is losing money go out of business? Eventually (most sooner rather than later). There are always exceptions to the rule.
The Decision to Operate or Shut Down: The Short Run
A firm has two options in the short run: operate or shut down. When TR > VC, operate. If it operates, it will produce the output that will yield the highest possible profits. If it is losing money, it will operate at that output at which losses are minimized. When TR < VC, shut down. If the firm shuts down, output is zero. Shutting down does not mean zero total costs. The firm must still meet its fixed costs. Remember, at an output of zero, TC = FC. The firm can not go out of business until all fixed cost obligations are eliminated.
Diseconomies of Scale
Diseconomies of scale: the inefficiencies that become endemic in large firms. Evidenced by the rising part of the ATC curve In general, at some point, the larger firms get the more inefficient they become. Reasons are: An expanding and growing bureaucracy A huge and growing corporate authority Diseconomies of scale increase inefficiencies and also increase cost per unit.
Economies of Scale
Economies of scale: the economies of mass production, which drive down ATC. Evidenced by the declining part of the ATC curve In general, we expect large firms to undersell small firms. Reasons are: Quantity discounts Economies of being established Spreading fixed cost Economies of scale enable a business to reduce its cost per unit as output expands.
fixed costs
Fixed costs stay the same no matter how much output changes. Examples: rent, insurance, salaries, property taxes, and interest payments. Even when a firm's output is zero, it incurs the same fixed cost. Sometimes called "sunk cost" because once you have obligated yourself to pay them, that money has been sunk into your firm. The trick is to spread these (fixed) costs over as much output as possible. In other words, to spread your overhead over a large output.
MC is the cost of producing one additional unit of output.
It is best to use the VC column to calculate the MC. If the TC column is used, you cannot calculate the MC for the first unit of output.
The Production Function and the Law of Diminishing Returns
Production function: relationship between the maximum amount a firm can produce and various quantities of inputs. Marginal output: the additional output produced by the last worker hired. Law of diminishing returns: as successive units of a variable resource (say, labor) are added to a fixed resource, beyond some point, the extra or marginal product attributable to each additional unit of the variable resource will decline
Deriving the Shut-Down and Break-Even Points
The firm can make the same shut-down or operate decisions on the basis of price and average variable cost. Recall, a firm will shut down if VC > TR , or A firm will shut down if VC > P x Q Let's divide both side of the above equation by Output: VC > Price x Output Output Output AVC> PRICE= SHUTDOWN AVX<PRICE= OPERATE
Summing Up
The overlapping forces of increasing returns and economies of scale drive down ATC. Eventually, the overlapping forces of diminishing returns and diseconomies of scale push ATC back up again. The U-shaped ATC is very important in economic analysis and in business strategy. What size plant do we build? How many workers do we hire? What is the output at which our firm would operate most efficiently?
variable costs
Variable costs vary with output. As output goes up, VC goes up. As output goes down, VC goes down. Examples: wages, fuel, raw materials, electricity, and shipping. Sometimes a cost may be part fixed and part variable. The electricity used by production is a variable cost because it will go up or down with production. Even if your output fell to zero, you would still have to pay something on your electric bill which makes this a fixed cost.
Each of these ATCs represents a different size factory, with a different optimum level of output represented by the minimum point on the ATC curve.
ATC1 has the lowest capacity while ATC5 has the highest. Changes in plant size are long run changes. In the long run, a firm could be virtually any size provided it has the requisite financing
long run
The long run is the time at which all costs become variable costs. Never exists except in theory...you never really reach the long run. You will never have a situation in which all your costs are variable. This would mean no rent, no insurance, no guaranteed salaries, no depreciation, etc. As you proceed through the short run, you are forced to make decisions that will push the long run farther into the future.