A Couple of Equations

average cost

=

total cost quantity of output

This equation can be turned on its head to calculate total cost from average cost:

total cost = average cost x quantity of output

Three Averages

• Average Total Cost: This is per unit total cost, or total cost divided by the quantity of output produced. Average total cost is also the sum of average fixed cost and average variable cost.


• Average Fixed Cost: This is per unit total fixed cost, or total fixed cost divided by the quantity of output produced. Because fixed cost does not vary with output, average fixed cost declines with larger quantities of production.


• Average Variable Cost: This is per unit total variable cost, or total variable cost divided by the quantity of output produced. Average variable cost is influenced by short-run marginal returns, decreasing for small quantities, then increasing for larger quantities.

Short-run Production Analysis

This price-average cost comparison is just the sort of thing that can keep a firm from bankruptcy. In fact, those firms that have some degree of control over price, frequently set prices based on average cost. The most common techniques used are mark-up pricing or cost-plus pricing, which ensure that firms cover cost and receive a profit on each unit sold.

Suppose, for example, that the average cost incurred by Waldo's TexMex Taco World in the production of Super Deluxe TexMex Gargantuan Tacos is $3. If each Super Deluxe TexMex Gargantuan Taco sells for $3.50, then Waldo's TexMex Taco World receives $0.50 per taco. In all likelihood, Waldo's TexMex Taco World sets the price at $3.50 for their Super Deluxe TexMex Gargantuan Tacos by adding a "reasonable" fifty-cent per taco profit to the three dollar per taco cost.

Profit, Loss, or Shutdown

• Produce at a Profit: The first alternative, the one sought after by profit-maximizing firms, is to generate a positive profit on output produced. This is achieved if price is equal to or greater than average total cost.


• Produce at a Loss: A second alternative is to produce output in the short run, even though profit is negative, that is, the firm incurs a loss. This is achieved if the price is greater than average variable cost, but less than average total cost. The loss from production is less than the fixed cost loss that would be incurred by shutting down production.


• Shutdown Production: The last alternative is to stop producing in the short run and incur the loss of fixed cost. This is achieved if price is less than average variable cost. The loss from production is greater than the fixed cost loss incurred by shutting down production.