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Production and Cost Review for AP Economics (page 2)

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By — McGraw-Hill Professional
Updated on Mar 2, 2011

Graphically Speaking

Marginal product is the incremental change in total product as one more unit of labor is added. Marginal product is the geometric slope of total product. In Figure 8.1, the total product curve is initially getting steeper as more labor is added. This is seen in Figure 8.2 as increasing marginal product. From the third to the fifth worker, the slope of total product is still positive, but is becoming less steep. In Figure 8.2 marginal product from workers 3 to 5 is still positive but is falling. Beyond the fifth worker, total product is falling and thus has a negative slope. This turn of events is seen below when marginal product becomes negative.

Average product, also plotted below, initially rises, reaches a peak, and then begins to fall. So long as the marginal (next) worker adds production that is above the current average, they are pulling the average up. This is why we see APL rising so long as MPL is above APL. If the marginal worker adds production that is below the current average, the worker pulls the average down. Thus when MPL is below APL, you see that APL is falling. Logically then, MPL intersects APL at the peak of APL. Average product cannot be negative.

Production and Cost

Short-Run Costs

It is important to note that we have discussed production theory without including the nagging necessity of paying for our hired inputs. For every employed input, fixed or variable, a cost is incurred.

Total Costs

In the short run, there is at least one input that is fixed and so these costs are also fixed. All inputs that are variable incur variable costs.

  1. Total Fixed Costs (TFC) are those costs that do not vary with changes in short-run output. They must be paid even when output is zero. These include rent on building or equipment, insurance or licenses.
  2. Total Variable Costs (TVC) are those costs that change with the level of output. If output is zero, so are total variable costs. They include payment for materials, fuel, power, transportation services, most labor, and similar costs.
  3. Total Cost (TC) is the sum of total fixed and total variable costs at each level of output.

TC = TVC + TFC

Production and Cost

Table 8.3 summarizes Molly's costs of producing cups of lemonade per minute. Her total fixed costs are assumed to be $6 per minute and total variable costs increase as production increases.

Figure 8.3 illustrates the three total cost functions. Total fixed cost is a constant at all levels of output. Total variable cost quickly rises at first, briefly slows, and then proceeds to increase at an increasing rate. Total cost is simply the sum of TFC and TVC at every level of output and so it lies parallel to TVC. Thus the vertical distance between TC and TVC is equal to TFC.

Marginal and Average Costs

Similar to our discussion of production, we can derive marginal and per unit measures of cost from the total cost functions. These are in Table 8.4.

  1. Marginal Cost is the additional cost of producing one more unit of output MC = ΔTC/ΔQ. Since TVC are the only costs that change with the level of output, marginal cost is also calculated as MC = ΔTVC/ΔQ. If quantity is changing one unit at a time, MC = ΔTC = ΔTVC.
  2. Average Fixed Cost (AFC) is total fixed cost divided by output. AFC = TFC/Q. It continuously falls as output rises.
  3. Average Variable Cost (AVC) is total variable cost divided by output. AVC = TVC/Q.
  4. Average Total Cost (ATC) is total cost divided by output ATC = TC/Q. Note that ATC = AFC + AVC.
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