Microeconomics Monday-Cost Curves and Concepts

The beauty of microeconomics is it models the economics of the firm. Economics at that level isn’t some pie in the sky science. It’s a real life actionable decision making framework. Do you wonder what executives talk about in meetings? This stuff that follows.  Yes, there is some math in this post, but you can figure it out!

There are some assumptions we have to make in order to present the topic. First, the firm is a price taker. Price (P) is fixed. We also assume that the firm chooses to produce the quantity (Q) needed to maximize it’s profit. They aren’t taking risk for their health! What does Q equal? The scale of a firms operations. When quantity changes we’re thinking about changing capacity or scale.

Companies distinguish between the short and long run. Their definition varies across industries. Traditionally, economics profs may have said the short run is less than one year but that may or may not be true. Short runs have contraints on them. Limits on capacity, types of inputs. There even may be costs in the short run if the firm shuts down and chooses not to produce. In the long run, the firm has maximum flexibility over just about everything, (scale, inputs, methods, technology) and can also shut down.

What does the word “cost” mean when we are talking economics? Profit=Total Revenue-Total Cost or PQ-TC(Q). Revenue comes from the demand curve. Total cost is a function of Q. Since companies try to profit maximize, they try to minimize costs. Total cost is the minimum cost of producing Q efficiently.  This is a big picture concept.

There are different ways to think about costs.  Accountants (and government budgeters) say that costs are an explicit expenditure.  In Economics, costs can also be implicit.  That’s why economists always total up the opportunity costs as well as the accounting costs.  Opportunity costs are the net value of the sacrifice opportunity, or best alternative.  In investing, you can invest $1000 in a stock, or put it in a bond.  The actual cost is the cost to buy the stock, plus the opportunity cost of investing in the bond (including the guaranteed rate of return).  Your profit is the return on the stock, minus all the costs.

When you ignore opportunity costs in decision making, you are guaranteed to make bad decisions.  Many times, people just look at the accounting numbers and make a choice.  This ultimately leads them down the wrong path.

Costs are also always forward looking.  Only costs that can be managed are considered.  Avoidable costs are costs once made that can be recovered.  Costs of equipment that can be recouped by selling it.  Sunk costs are expenses that once spent, cannot be recovered.  When making decisions, you never add sunk costs into the equation.  ”Never cry over spilled milk” is a similar adage.

Here is an example to ponder:  A few weeks ago, you spent $50 bucks on a theatre ticket.  You arrive at the theatre, and lost your ticket.  Will you pay $50 for a comparable ticket to see the show?  Let’s change it slightly.  You lost $50 in cash, but have a ticket.  Would you sell the ticket for $50 and not see the show?  What are the sunk costs?  What costs are avoidable?

When considering costs, they are plotted out using curves.  There are seven cost curves that are utilized to make decisions.  First is the Total Cost (TC) curve.  Total Costs=Fixed Costs + Variable Costs.  Companies produce at the lowest total cost for the quantity produced.  Second are fixed costs.  The Fixed Cost (FC) curve are all costs that have to be paid no matter how much quantity is produced.  Third are variable costs.  Variable Cost (VC) curves change with the amount produced.  If the cost isn’t fixed, then it’s variable.  Fourth are marginal costs.  Marginal Cost (MC) curves change with the production of one more unit of Q.  They are never negative-it’s never cheaper to produce more.

MC=change in TC, and also the change in VC.  The math looks like this:

MC=dTC/dQ=d(FC+VC)/dQ=dVC/dQ  or non calculus way of looking at it:  MC=∆TC/∆Q=∆VC/∆Q

MC is the slope of TC or VC.  How cost changes is ultimately related to variable costs.

The VC is the sum of all the MC’s, or VC=∑MC

Marginal costs tend to rise with higher production, even in scalable internet businesses.  This is called the law of diminishing returns. Eventually, there it’s a losing proposition to produce another because the cost to do it outweighs the revenue received. They are different than fixed costs. The more you produce, the less average fixed cost goes into a good. You might be losing money on lower average fixed costs of production because marginal costs are eating profit.

What does the MC curve look like?

Then there are average costs. Average costs are like average fixed costs. Here is the math:
AC =TC/Q=(FC+VC)/Q=(FC/Q)+(VC/Q)=AFC+AVC

Average fixed costs decrease with higher production. But average variable costs don’t. AVC is dependent on MC. MC intersects AVC and AFC at their minimums. Here is a graph.

Why does this matter? Because eventually, all costs will rise with marginal costs and if we produce too much, we lose money.

It takes awhile to get comfortable with a lot of these cost concepts.  They can be difficult to tease out in real world situations.  In everyday situations, it’s doubtful that you ring up the costs inside your head and make a decision.  But, through learning and habit you actually do.  Everyone tries to go about their day in the most efficient way possible, calculating all the opportunity costs along with every decision you make.  Even when you differ from the way you normally do things, perhaps you drive home a different way from work-there is a cost and opportunity cost to that action.  As soon as there are those two costs, you can begin to put together the rest of the cost analysis to see how costs scale and how you can produce the most efficiently.

These cost concepts also explain why Atlas shrugged in Ayn Rand’s book.  Some people think that is happening today as businesses total up the marginal cost to produce and either choose to exit their industry, or to cut back on production to stay profitable.

ADDENDUM

See the curves on the graphs?  This is why it’s important to take some sort of calculus when you are in college regardless of your major. Costs are not a simple point-they are a continuum.  Same with revenue.  When we think about real life issues, most of our life is set up as a fixed cost.  Rent, car payments, house payments etc are all fixed.  Once you enter into a contract, it is hard to get out.  Variable costs are food, energy, cost of insurance, vacation, clothing, what kind of car we drive etc.  See if you can figure out a way to graph your personal cost curves.  You might use Smarteys to try.

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