Producer theory, average, marginal, fixed, total costs… oh my!

There are a lot of costs that you have to memorize (scratch that) LEARN in microeconomics.  Here is a list of the costs, followed by their equation and definition with some explanation.

Total Cost (TC): (FC+VC) or AC*Q.  Total cost is the cost of everything used by the firm in production, it is the total of all the costs (sorry, I can’t think of another way to say it J).

Fixed Costs(FC), also known as Total Fixed Costs (TFC): (TC-VC) or AC*Q-VC.  Fixed costs are the easiest to remember because they are fixed.  This is the cost associated with expenses that you can’t change, and only occur in the short run.  Common fixed costs are rent, electricity, or other contractual obligations.

Variable Costs (VC), also known as Total Variable Costs (TVC): (TC-FC) or AC*Q-VC.  Variables costs are the costs that change as you produce more.  For example, if you want to make more burritos, your need more tortillas, so the money you spend on tortillas is a variable cost because it changes with the amount of burritos you make.

The above costs are the ones present in our check book or accounting software.  They represent the amounts that we are actually paying to keep our company running.  However, in order to make economic decisions, we also need to consider the following costs, which require a bit of calculation:

Average Cost (AC): TC/Q.  To get this just divide your total cost by the quantity produced.  

Average Fixed Cost (AFC): FC/Q.  This is easy to calculate, just take your fixed costs and divide by the number of units produced.  Since your fixed costs don’t change, as you produce more and more output, you will see your average fixed costs go down.

Average Variable Cost (AVC): VC/Q.  This one is also easy to calculate, but a little tricky to interpret.  Just divide your total variable costs by your quantity produced.  Since variable costs vary with the amount produced, you won’t see a definite relationship with average variable cost, as you would with average fixed cost.

Marginal Cost (MC): (difference between TC).  To get your marginal cost you will have to look at the difference between your total costs at different quantities.  For example, if your TC was 50, and then went to 55 with one more unit of production, than your MC is 5.  Marginal cost is the most important of the costs because as economists, we analyze everything on the margin.

Future posts will go through the graphical representation of these costs for a typical firm, as well as some guided solution examples.

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