Unit 2 --- First Reading Assignment --- 
READING ASSIGNMENTS
UNIT TWO (FOR EXAM TWO)
Unit 2 --- First Reading Assignment ---
Your first reading assignment for Unit Two is pp. 557-569. Study the distinction between the long-run and the short-run on p. 559. The short-run is a time frame over which long-run adjustments cannot be made. That is, the short-run is a period of time during which a business firm cannot change its current set of plant, equipment, tools, and machinery.
Look at the production function, which may be represented graphically or in the form of a table, on page 560.
Note the definition of marginal product on p. 560.
Study carefully all of the cost concepts presented in the table on p. 563. Here are some observations about the various cost concepts:
Total fixed costs: These expenses depend on the fixed plant and equipment and permanent organization of a business firm. They do not vary with changes in output. Examples include rent, real estate taxes, and depreciation on buildings and equipment. Total fixed costs at a production level of zero are equal to total fixed costs at any higher level of output. At a zero level of short-run production, all costs are treated as fixed. Note that average fixed cost = total fixed cost divided by the amount of production. As output rises, AFC will decline, although at a decreasing rate.
Variable costs: These are expenses that vary significantly depending on the current level of production. Examples include the wage costs of production employees and the cost of materials and supplies. Total variable costs equal total cost minus fixed cost. Total variable costs will rise as production increases. Average variable cost is just total variable cost divided by the amount of production. A typical pattern is for AVC to drop at first, then turn around and begin to rise.
At a very low level of production, a firm will normally be inefficient because it is unable to spread out its fixed costs over a high enough amount of production. That is, average fixed cost (fixed cost divided by output) is too high.
AFC is the fixed cost amount on a per unit basis. Be sure to distinguish total fixed cost from average fixed cost. To calculate average fixed cost, just divide total fixed cost by the level of output.
At some very high rate of production, a business firm will become inefficient because its variable costs will start rising rapidly (e.g., excessive overtime pay). On a per unit basis, average variable cost will become too high.
Total cost: Add the fixed cost and the variable cost (FC + VC = TC). To calculate Average Total Cost, divide total cost by the amount of production. Make sure you don't confuse total cost with average total cost.
Marginal Cost: This is a key concept in microeconomics and you should learn it well.It is defined as the change (i.e., difference) in total cost divided by the change in the quantity of production. In the table on p. 563, several marginal cost calculations are shown. Note that the output change in each case is one unit (e.g., 3 to 4, 9 to 10, 16 to 17, etc.). This makes it easy to figure marginal cost on a per unit basis because once you determine the change in total cost, you have the answer. In some production functions, the changes in production will be in larger amounts, such as:
| OUTPUT | TOTAL COST | MARGINAL COST |
| 1000 | $8,800 | ------ |
| 1200 | 10,100 | $6.50 |
| 1400 | 11,500 | $7.00 |
The top row in the marginal cost column is left empty because we are not comparing to any previous total cost amount. The first change in total cost is $1,300 ($10,100 less $8,800). The first change in monthly production is 200 (1200 minus 1000). So the first marginal cost result is $1,300 divided by 200 or $6.50. It is often true that production changes will be in groups of 100 or 1000 or larger. In those cases the change in total cost must be divided by a number larger than 1 (in the example above, 200) in order to calculate marginal cost on a per unit basis. Division by 1 is convenient and many production functions shown in textbooks present the data this way. Just remember to check the output changes in the left-hand column and divide the total cost changes accordingly.
Now calculate the second marginal cost result in the table above and verify that it is $7.00.
Refer again to the table on p. 563. Notice that marginal cost drops at first (from $12 to $8 to $7) and then goes up (from $7 to $10 to $15). This is a typical pattern. Why? Because the firm is able to achieve certain efficiencies with its variable costs as output rises. Note that marginal cost operates only on variable costs, not fixed costs. However, as output continues to increase, per unit variable cost (i.e., average variable cost) will turn around and begin to increase.
If you examine the average fixed cost column (AFC), you'll notice that while the AFC numbers continue to drop as output rises, they do so at a decreasing rate. Eventually, variable costs rise substantially and cause average total cost to increase. Note the turnaround in the average variable cost column (AVC) as output increases from 22 to 23. Even after AVC starts to increase (e.g., from $9.09 to $9.13), average total cost (ATC) can continue to decrease (from $11.36 to $11.30) because the amount of decrease in AFC exceeds the amount of increase in AVC. However, when production goes from 27 to 28, ATC turns around and begins to rise. Now the amount of increase in AVC exceeds the amount of decrease in AFC.
Note that the only way an average value (e.g., AVC or ATC) can rise is if the marginal value (MC) exceeds the average. When this occurs, the higher marginal value will pull up the average. In other words, that fact that MC is increasing does not necessarily mean that AVC or ATC is increasing. AVC and ATC will rise only if MC exceeds AVC or ATC. In the graphs on pp. 565 and 568, you will notice a range of output in which MC rises while AVC and ATC continue to fall. This occurs because the MC value, while rising, is less than the AVC and ATC values.
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