ECON101: Principles of Microeconomics (2021.A.01)

Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.

Whatever the firm's quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter Choice in a World of Scarcity, fixed costs are often sunk costs that cannot be recouped. In thinking about what to do next, sunk costs should typically be ignored, since this spending has already been made and cannot be changed. However, variable costs can be changed, so they convey information about the firm's ability to cut costs in the present and the extent to which costs will increase if production rises.

CLEAR IT UP

Why are total cost and average cost not on the same graph?

Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. These costs are measured in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, they are measured as cost per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since they are measured in different units ($ versus $ per unit of output).

It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. But the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.

Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm's profit margin. Expanding the equation for profit gives:

$\begin{aligned} \text { average profit } &=\frac{\text { profit }}{\text { quantity produced }} \\ &=\frac{\text { total revenue }-\text { total cost }}{\text { quantity produced }} \\ &=\frac{\text { total revenue }}{\text { quantity produced }}-\frac{\text { total cost }}{\text { quantity produced }} \\ &=\text { average revenue - average cost } \end{aligned}$

But note that:

$\begin{aligned} \text { average revenue } &=\frac{\text { price } \times \text { quantity produced }}{\text { quantity produced }} \\ &=\text { price } \end{aligned}$

Thus:

$\text { average profit }=\text { price }-\text { average cost }$

This is the firm's profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative.

The marginal cost of producing an additional unit can be compared with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit – or not. Thus, marginal cost helps producers understand how profits would be affected by increasing or decreasing production.