IntroFrms - Industrial Organization: EC460 Spring 2009...

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Industrial Organization: EC460 Spring 2009 Instructor: Thomas D. Jeitschko Introductory Notes on the Firm Consider a firm with the following cost function, C ( q ) = q 2 + 100. Here the first term is the variable cost, and the second term is the fixed cost, i.e., V C ( q ) = q 2 and FC ( q ) = FC = 100. In order to determine profit-maximizing strategies, however, we need to look at the notions of marginal and average costs. These are defined as: Marginal cost ( MC ): The firm’s marginal cost is a concept that pertains to (infinites- imally small) changes in the amount a firm produces at varying levels of total output. Specifically, MC measures by how much a firm’s costs will increase [decrease] if the firm increases [decreases] its current output by one more [fewer] (infinitesimally small) unit[s]. Average cost ( AC ): The firm’s average cost is a cost concept that pertains to the total level of output of the firm. It measures how much—on average—a unit of output costs the firm given its current level of production. As such, it is often also referred to as the unit cost of production (given the level of output that the firm produces). Just as we distinguish between variable costs and fixed costs as components of total costs, we can make a similar distinction here: the portion of unit costs that cover the variable costs are the average variable costs, those attributed to fixed costs, such as overhead, are average fixed costs: AC = AV C + AFC . Since the marginal cost is defined as the change in costs as the firm incrementally changes its output q , this is the derivative of the cost function (or, since fixed costs don’t change 1
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when the changes its output, it is also the derivative of the variable cost function). For our example, we get MC ( q ) = d dq C ( q ) = C 0 ( q ) = 2 q . Average costs are obtained by dividing the total cost of the firm by the number of units the firm is producing. In our example this is AC ( q ) = C ( q ) q = q 2 +100 q = q + 100 q . These are made up of average variable costs, AC ( q ) = AV C ( q ) + AFC ( q ) = V C ( q ) q + FC q = q + 100 q . A general observation is that marginal costs are exactly equal to average costs at the output at which the firm’s average costs are at a minimum. At smaller levels of output the marginal cost is below the average cost and the average cost is decreasing; at larger levels of output the marginal cost is above the average cost and average cost is increasing. Recalling the definitions of marginal and average cost, this relationship is no coincidence. That is, whenever the cost of producing one more unit of output is smaller than the unit costs are, producing more units will decrease unit costs (so AC is decreasing whenever MC < AC ). By the same token, whenever producing additional units costs more than unit costs are at that point, an increase in output will increase the average cost of output (so that AC is increasing whenever MC > AC ). Consequently, it must be the case that at
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This note was uploaded on 03/29/2009 for the course ECON 460 taught by Professor Boyer during the Spring '08 term at Michigan State University.

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IntroFrms - Industrial Organization: EC460 Spring 2009...

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