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 4 graphs Thelma’s costs using the data from Table 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 the marginal-cost curve, the shape of the average-total-cost curve, 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 produces a small quantity of lemonade, she has few workers, and much of her equipment is not 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.

U-Shaped Average Total Cost Thirsty Thelma’s average-total-cost curve is V-shaped, as shown in Figure t!. To understand why, 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.

The Relationship between Marginal Cost and Average Total Cost If you look at Figure 4 (or back at Table 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.

Figure 4 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

This relationship between average total cost and marginal cost has an important corollary: The marginal-cost curve crosses the average-total-cost curve at its minimum. 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 muststart 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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