Cost Curves And Their Shapes
Just as in previous chapters we found graphs of supply and demand useful when analyzing the behavior of markets, we will find graphs of average and marginal cost useful when analyzing the behavior of firms. Figure 13-5 graphs Thelma's costs using the data from Table 13-2. The horizontal axis measures the quantity the firm produces, and the vertical axis measures marginal and average costs. The graph shows four curves: average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC).
The cost curves shown here for Thirsty Thelma's Lemonade Stand have some features that are common to the cost curves of many firms in the economy. Let's examine three features in particular: the shape of marginal cost, the shape of average total cost, and the relationship between marginal and average total cost.
Rising Marginal Cost Thirsty Thelma's marginal cost rises with the quantity of output produced. This reflects the property of diminishing marginal product. When Thelma is producing a small quantity of lemonade, she has few workers, and much of her equipment is not being used. Because she can easily put these idle resources to use, the marginal product of an extra worker is large, and the marginal cost of an extra glass of lemonade is small. By contrast, when Thelma is producing a large quantity of lemonade, her stand is crowded with workers, and most of her equipment is fully utilized. Thelma can produce more lemonade by adding workers, but these new workers have to work in crowded conditions and may have to
- (glasses of lemonade per hour)
Figure 13-5
Thirsty Thelma's Average-COST AND MARGINAL-COST Curves. This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) for Thirsty Thelma's Lemonade Stand. All of these curves are obtained by graphing the data in Table 13-2. These cost curves show three features that are considered common: (1) Marginal cost rises with the quantity of output. (2) The average-total-cost curve is U-shaped. (3) The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.
wait to use the equipment. Therefore, when the quantity of lemonade being produced is already high, the marginal product of an extra worker is low, and the marginal cost of an extra glass of lemonade is large.
U-Shaped Average Total Cost Thirsty Thelma's average-total-cost curve is U-shaped. To understand why this is so, remember that average total cost is the sum of average fixed cost and average variable cost. Average fixed cost always declines as output rises because the fixed cost is getting spread over a larger number of units. Average variable cost typically rises as output increases because of diminishing marginal product. Average total cost reflects the shapes of both average fixed cost and average variable cost. At very low levels of output, such as 1 or 2 glasses per hour, average total cost is high because the fixed cost is spread over only a few units. Average total cost then declines as output increases until the firm's output reaches 5 glasses of lemonade per hour, when average total cost falls to $1.30 per glass. When the firm produces more than 6 glasses, average total cost starts rising again because average variable cost rises substantially.
The bottom of the U-shape occurs at the quantity that minimizes average total efficient scale cost. This quantity is sometimes called the efficient scale of the firm. For Thirsty the quantity of output that Thelma, the efficient scale is 5 or 6 glasses of lemonade. If she produces more or minimizes average total cost less than this amount, her average total cost rises above the minimum of $1.30.
The Relationship between Marginal Cost and Average Total Cost If you look at Figure 13-5 (or back at Table 13-2), you will see something that may be surprising at first. Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. This feature of Thirsty Thelma's cost curves is not a coincidence from the particular numbers used in the example: It is true for all firms.
To see why, consider an analogy. Average total cost is like your cumulative grade point average. Marginal cost is like the grade in the next course you will take. If your grade in your next course is less than your grade point average, your grade point average will fall. If your grade in your next course is higher than your grade point average, your grade point average will rise. The mathematics of average and marginal costs is exactly the same as the mathematics of average and marginal grades.
This relationship between average total cost and marginal cost has an important corollary: The marginal-cost curve crosses the average-total-cost curve at the efficient scale. Why? At low levels of output, marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost. For the reason we have just discussed, average total cost must start to rise at this level of output. Hence, this point of intersection is the minimum of average total cost. As you will see in the next chapter, this point of minimum average total cost plays a key role in the analysis of competitive firms.
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