2. Microeconomics continued

2. Microeconomics continued - 2 Microeconomics continued...

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2. Microeconomics continued Cost Theory: fixed, variable, total, average and marginal costs Economists try to use language precisely. The words cost and price are often confused. When we discuss costs we mean, how much did something cost to produce. This might be expressed as an opportunity cost, or in a currency such as dollars. When price is mentioned, economists mean the amount the consumer pays. Economists also try to explain the nature of costs. Why does one thing cost more to produce than another? Why does making an airplane cost so much less in a big factory than in a small factory. To help explain, total costs are broken down into several parts and looked at in different ways. Before we start we make one basic assumption, that the firm is operating in the short-run time period. Fixed costs If aircraft are to be made then a factory is required. The land, the factory building, the machinery and office equipment must be bought or rented. These costs are called fixed costs and must be paid even when the factory has not produced anything. Fixed costs are costs that do not change, whatever the level of output is. Assuming an airplane factoryís fixed costs is a \$60 million. See Table 1. below. A graph of the fixed costs (FC) would look like this; Variable costs and total variable costs Variable costs do change as the level of output changes. These costs are costs such as raw materials in production. In our example this would be the steel, components and labour needed to make each airplane. If nothing were made the variable costs would of course be nothing. But as production rises the total variable costs (TVC) would rise. The variable cost is the cost per unit. The total variable cost is found by multiplying the variable cost (VC) by the level of output (Q), so TVC = VC x Q. Assuming that variable costs are constant at \$1 million per airplane, a graph of

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TVC would look like this; Total costs Total costs are simply the sum of the total variable costs and the fixed costs. Note that the TC and TVC lines are parallel. The distance between the two lines is the amount of the fixed costs. Table 1.
Output Fixed cost Total variable cost Total cost 0 60 0 60 10 60 10 70 20 60 20 80 30 60 30 90

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Distinction between short-run and long-run Economic models usually begin with a statement about their assumptions. One of the assumptions is usually concerned with the time period involved. We always need to know if a model is a short-run or a long-run model. What economists mean by time period is not the same as a physicist or mathematician. Time periods in economics are not measured with a stop- watch in minutes, hours or days. Rather, the short-run and long-run are more like philosophical concepts. The short-run
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This note was uploaded on 02/12/2010 for the course ECON 201 taught by Professor Smith during the Spring '10 term at Whittier.

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2. Microeconomics continued - 2 Microeconomics continued...

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