The Cost of Production 239The total cost of achieving any given level of output can be divided into two
parts: fixed and variable costs. As the term suggests, fixed costsresult from the
firm’s expenditures on fixed inputs. These costs are incurred regardless of the
firm’s level of output. Most overhead expenses fall into this category. Such costs
might include the firm’s lease payments for its factory, the cost of equipment,
some portion of energy costs, and various kinds of administrative costs (pay-
ment for support staff, taxes, and so on). According to the table in Figure 6.1,
the repair firm’s total fixed costs come to $270,000 per year. These costs are
incurred regardless of the actual level of output (i.e., even if no output were
produced).
Variable costsrepresent the firm’s expenditures on variable inputs. With
respect to the short-run operations of the repair firm, labor is the sole variable
input. Thus, in this example, variable costs represent the additional wages paid
by the firm for extra hours of labor. To achieve additional output (i.e., to
increase the volume of repair jobs completed), the firm must incur additional
variable costs. Naturally, we observe that total variable costs rise with increases
in the quantity of output. In fact, a careful look at Figure 6.1 shows that vari-
able costs rise increasingly rapidly as the quantity of output is pushed higher
and higher. Note that the firm’s total cost exhibits exactly the same behavior.
(With fixed costs “locked in” at $270,000, total cost increases are due solely to
changes in variable cost.) The graph in Figure 6.1 shows that the total cost
curve becomes increasingly steep at higher output levels.
Average total cost(or simply average cost) is total cost divided by the total
quantity of output. Figure 6.2 shows average costs for the repair company over
different levels of output. (Check that the average cost values are computed as
the ratio of total cost in column 2 of the table and total output in column 1.)
The graph displays the behavior of average cost. Both the table and graph show
that short-run average cost is U-shaped. Increases in output first cause average
cost (per unit) to decline. At 30,000 units of output, average cost achieves a
minimum (at the bottom of the U). As output continues to increase, average
unit costs steadily rise. (We will discuss the factors underlying this average cost
behavior shortly.) Finally, average variable costis variable cost divided by total
output. Because it excludes fixed costs, average variable cost is always smaller
than average total cost.
Marginal costis the addition to total cost that results from increasing out-
put by one unit. We already are acquainted with the concept of marginal cost
from the analyses of the firm’s output and pricing decisions in Chapters 2 and 3.
Now we take a closer look at the determinants of marginal cost. The last col-
umn of the table in Figure 6.2 lists the repair company’s marginal costs for out-
put increments of 5,000 units. For instance, consider an output increase from
25,000 to 30,000 units. According to Figure 6.2, the result is a total cost increase
of 1,440,000 1,207,500 $232,500. Consequently, the marginal cost (on a per-
unit basis) is 232,500/5,000 $46.50/unit. The other entries in the last col-
umn are computed in an analogous fashion. From either the graph or thec06CostAnalysis.qxd 9/29/11 1:46 PM Page 239