Average costs
The different nature of fixed and variable costs raises some intriguing questions about how to measure the cost of producing a pair of jeans. In figuring how much it costs to produce one pair, should we look only at the denim and labor time used to produce that pair? Or should we also take into account the factory rent and lease payments on the sewing machines?
A similar problem arises when you try to figure out whether a restaurant overcharges you for a steak dinner. What did it cost the restaurant to supply the dinner? Should only the meat and the chef’s time be counted? Or should the cost include some portion of the rent, the electricity, and the insurance?
The restaurant owner, too, needs to figure out which measure of cost to use. She has to decide what price to charge for the steak. She wants to earn a profit. Can she do so by charging a price just above the cost of meat and wages? Or must she charge a price high enough to cover some portion of all her fixed costs as well?
Before deciding which costs are most important for production and pricing decisions, we need to clarify a couple of key cost measures. We will focus on two: average cost and marginal cost.
Average total cost (ATC) is simply total cost divided by the rate of output; that is
If the total cost of supplying 10 steaks is $62, then the average cost of the steaks is $6.20.
As we observed in Figure 5.2, total costs change as the rate of output increases. Hence, both the numerator and the denominator in the ATC formula change with the rate of output. This complicates the arithmetic a bit, as Figure 7 illustrates.
Figure 7
Average Costs
Average total cost (ATC) in column 5 equals total cost (column 4) divided by the rate of output (column 1). ATC tends to fall initially, then later rise. This gives the ATC curve a U shape, as illustrated in the graph.
Figure 7 shows how average costs change as the rate of output varies. Row J of the cost schedule, for example, again indicates the fixed, variable, and total costs of producing 15 pairs of jeans per day. Fixed costs are still $120 (for factory and machine rentals); variable costs (denim and labor) are $125. Thus the total cost of producing 15 pairs per day is $245. The average cost for this rate of output is simply total cost ($245) divided by quantity (15), or $16.33 per day. This ATC is indicated in column 5 of the table and by point J on the graph.
An important feature of the ATC curve is its shape. Average costs start high, fall, then rise once again, giving the ATC curve a distinctive U shape.
The initial decline in ATC is largely due to fixed costs. At low rates of output, fixed costs are a high proportion of total costs. Quite simply, it's very expensive to lease (or buy) an entire factory to produce only a few pairs of jeans. The entire cost of the factory must be averaged out over a small quantity of output. This results in a high average cost of production. To reduce average costs, we must make fuller use of our leased plant and equipment.
The same problem of cost spreading would affect a restaurant that only served two dinners a day. The total cost of operating a restaurant might easily exceed $500 a day. If only two dinners were served, the average total cost of each meal would exceed $250. That's why restaurants need a high volume of business to keep meal prices low.
As output increases, the fixed costs of production are distributed over an increasing quantity of output. Fixed costs no longer dominate total costs as production increases (compare columns 2 and 3 in Figure 7). As a result, average total costs tend to decline.
Average total costs don't fall forever, however. They bottom out at point M in Figure 7, then start rising. What accounts for this turn around?
1. Formulate the main idea of the text.
2. Find in the text English equivalents of these words and phrases.
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12. давати прибуток |
23. форма, обрис |
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13. з'ясовувати, вносити ясність |
24. відповідно до |
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14. граничні витрати |
25. скоротити |
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15. підпадати, зазнавати |
26. середні витрати |
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16.загальна продуктивність |
27. впливати на щось |
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17. повна собівартість |
28.перевершувати, перевищувати |
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18. числівник |
29.розподіляти, поширювати |
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19. знаменник |
30.панувати, переважати |
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20. ускладнювати(ся) |
31. дійти до суті чогось |
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21. крива |
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22.відмітний, характерний |
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3. Are these statements true or false? Correct the false ones.
Average cost is simply total cost divided by the quantity produced.
The ATC curve is typically U shaped.
ATC tends to rise initially, then later fall.
The initial decrease in average total cost is always due to fixed costs.
It’s not very costly to purchase an entire factory to produce only a few pairs of jeans.
Fixed costs dominate total costs as production grows.
Average total costs don’t drop forever.
4. Answer the questions.
Why the shape is an important feature of average total cost curve?
What costs tent to decline?
5. Write a summary of the text.
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