We spent a couple of days working on total production, average and marginal and blending those understandings into cost curves. Diminishing marginal returns sets in very quickly with just one waffle maker (fixed capital).
So, was looking at questions with students and had a good time talking about this one.
Answer - (B) Spreading fixed costs over a larger output, and eventually diminishing returns.
Often, I explain the U-shaped curve as a reflection of Diminishing Marginal Returns and then stop but this question caused me to think about not only the rise in cost but the fall in costs.
If we look at a graph of the Average cost curves we see ATC with its U-Shape and we see AVC with its U-shape but AFC tends to decrease with more output.
This is because as output increases the average of the total fixed costs, per-unit decreases.
If your total fixed costs are $100 (rent) and you sell 1 unit, (wauffle), your total fixed costs are still $100 but
your Average fixed costs are $100 (OK be patient)
But if you sell a second waffle
then your Average Fixed costs are now $50
TFC/Q (output) = Average Fixed Costs, so $100/ 2(output) = $50
This decreasing AFC pulls down the ATC curve.
Lets use some numbers - ATC(5) = AVC (3) + AFC (2)
If average fixed costs decreases (as output increases) then ATC (4) = AVC (3) + AFC (1)
AFC decreases and therefore ATC has to decrease,, thus the falling of the curves.
ATC Curve is pulled down by the effect of AFC decreasing as output increases and pulled up as diminishing returns sets in.
To understand Nominal and Real we must first understand the concepts of Inflation and Purchasing Power
Inflation is an increase in the average price level of goods and services in a nation over time.
(If the price of apples is increasing, and the reason is because of a flood or a drought, then this is not spoken of as inflation as the cause is specifically from a flood/draught) If the price of all goods in the country are rising then we have Inflation. (Often caused by increases in the supply of a country's currency)
Purchasing Power is the number of goods or services that can be purchased with a unit of currency.
Nominal wages = current wages
Nominal wages (Income) is the amount of money I am paid at a certain period of time. If I'm paid $12 an hour, then my nominal wage is $12 dollars and hour. A nominal wage is expressed in the country's currency. If apples cost $1 each, then I have the ability (purchasing power) to buy 12 apples.
Time Passes, (let's say a year) and Inflation occurs, Apples have risen in prices to $2 each.
I'm in the US and my wage is $12 an hour, that is my nominal wage (income), and the purchasing power of my nominal wage is 6 apples at a cost of $2 each. Due to inflation my hourly wage of $12 has been reduced. I use to be able to purchase 12 apples for an hour's work but now I can only buy 6. My purchasing power has been reduced by 50%.
Real Wage = (purchasing power of wages, what it will buy, nominal wages adjusted for inflation)
If your income stays the same and inflation (price level rises) occurs, then your real wage has decreases.
If your income stays the same and instead of inflation there is deflation (price level falls), then your real wage has increased.
If your income stays the same and there is no inflation, then your real wage is your nominal wage
Nominal Wages = Real Wages (if there is no inflation = 0%)
If your wage (income) is $12 an hour, and there is no inflation (price level=no change) then $12 is your real wage.
Real Wages = Nominal Wages - Inflation
If your nominal wage is $12 an hour and inflation is 50% then your real wage would be equal to $6 an hour. A 50% increase in inflation will cause ones real wage to be 50% lower than the nominal wage.
So, lets look at this 2010 problem. If the workers nominal wage increased from $10 to $12 then the wage increased by 20%. Yet, at the same time inflation (price level) increased by 10%.
So, wages increased by 20% and inflation increased by 10%.
IF you gain 20% and inflation (eats) ten of that 20%, you are left with 10%, the answer is C.
Nominal Wages = Real Wages (Inflation = 0%)
$10 = $10
Real Wages = Nominal Wages - Inflation
$9 = $10 - $1 (Inflation increased by 10%, this equals $1 of a $10 wage)
Real Wages = Nominal Wages - Inflation
$8 = $10 - $2 (Inflation increased by 20%, this equals $2 of a $10 wage)
As MSC > than MPC, the externality is a negative production externality.
At a quantity of Q2, MSB = MSC at a price of $12.
The government can incentivise the monopolist to produce more by providing a subsidy. A subsidy should be provided to the point where the monopolists MC (MPC) curve will be reduced until it intersects with the MR (MPB) curve at Q2 (social optimal quantity)
A Perfectly competitive firm would produce an overproduction of a negative production externality. Its market price is where MPC = MPB and this is at the price of $7 and at a quantity of Q3. To get the perfectly competitive firm to produce less a per-unit tax must be levied against the (industry). As the firm has no control over price (price-takers) the industry must have the tax imposed upon it. At a tax of $5 the price would rise to $12 and the quantity would be reduced to Q2. Or what I believe to be the socially optimal quantity and price.
Students were asking why the government would subsidise a monopoly to create more negative goods,,, I believe the answer is to recognise that even a negative production externality has a benefit to society. Pollution might be the problem,, but no pollution means no production and this would be much worse than the externality. So government recognises that there is a benefit in the production of the good.
Understand that the marginal benefit should equal the marginal cost. (MB = MC) or the MSC = MSB.
We could spend trillions of dollars to clean all of the rivers and lakes but then the MSC > MSB. Society would have pristinely clean rivers but not much of anything else.
Thank you Michelle for bringing this to my attention,,
Such fun I've had today,, trying to figure this out.
This section has quite a few moving parts and therefore is best studied in sections. Lets start with costs.
Costs
exist because resources are scarce and have alternative uses.
(This makes sense in that owners of resources are competing with other owners to sell their goods (labor) to the highest bidder) Employers and producers are competing with each other to buy the cheaper goods or hire labor at a lower price. Often the fallacious idea is that employers and employees are in competion with one another. This is false, employers are in competition with other employers and employees are in competition with other employees. The employee who pays more wins, (how does this translate to competition between employer and employee?) Don't think me daft, I do understand that employees would like to be paid more and employers would like to pay less but I would like to pay less for the potatoes at the grocery store and yet I don't feel I'm in competition with the grocer.
OK, so Economic Costs are the payments (for goods) or
incomes it must offer (for people), to attract the resourcesfrom alternative production opportunities.
(Simple yes, to get someone to work for you you must be willing to pay them and they must accept)
We can separate (for the AP) two broad categories of costs.
Explicit Costs - (Accounting costs) – Money actually paid for
inputs for production. (Wages, electricity, input costs, transportation, etc)
Implicit Costs – Think, opportunity cost – money that could have been earned by the
entrepreneur with the nextbest alternative. Economists always take into account the implicit costs
in evaluating choices.
Total Costs - Fixed Costs -
Variable Costs
Total Fixed Costs – Costs that don’t vary with output. (Ex. Rent,
interest on loans, insurance premiums) These costs must be paid even if output is zero.
Even if the firm goes out of business these costsmust be paid.
Total Variable Costs – Costs that change with the level of output. (Ex.
Labor, materials, electricity, transportation) (For the AP when you see variable costs, think labor)
Total Costs – The sum of variable and fixed costs. (TC = FC + VC) or (TC = ATC x quantity of output)
Marginal Costs – The additional cost of producing one more unit of output.
Understand: the vertical distance between the TC & TVC curve is TFC.
Understand: the mathematical relationship between the cost curves.
TC = TVC + TFC (5 = 3 + 2)
TVC = TC – TFC (3 = 5 - 2)
TFC = TC – TVC (2 = 5 - 3)
Be able to draw the Total Cost Graph - Understand: the vertical distance between the TC & TVC curve is TFC. (Obviously, if TC is TFC + TVC), then everything under the TVC is Total Variable Costs, while the difference between TVC and TC must be TFC
Think of the combination of the costs like this graph.
The area under the TVC curve is variable costs. (Labor, almost always the biggest part of a business)
and then the difference between TC and TVC is fixed costs.
Short-Run (Fixed & Variable Costs)Time Period
Short-Run – A time period in which a producer (a firm) is able to change the
quantities of some, but not
all of theinputs, factors of
production or resources they employ.
(Resources that can be adjusted are labor, and purchase of raw materials)
(The short-run has some resources that are fixed,
(Factory/Plant))
(Firms
cannot enter or exit the industry in the short-run)
Long –Run (All Costs are
Variable (Changeable))
Long Run – a time period in which producers
can change all of the resources they employ.
(In the long-run firms can enter and exit the industry)
(In the long-run there is no fixed costs as all costs are changeable, thus variable)
Short-run Production
Analysis (AFC, ATC, AVC)
Average Total Costs – A firms total costs divided by output. (TC/Q) or
(AFC + AVC = ATC)
Understand: As production increases,
initially there is a decrease in ATC at small levels ofproduction. As production
increases with larger quantities of production ATC increases to produce a U
shaped curve.
Average Variable Costs – A firms total variable costs divided by output. (TVC/Q)
or (ATC – AFC = AVC)
Understand: As production increases,
initially there is a decrease in AVC at small levels ofproduction. As production
increases with larger quantities of production AVC increases to produce a U
shaped curve.
Average Fixed Costs – A firms total fixed costs divided by output. (TFC/Q) or (ATC – AVC =
AFC)
Understand:average fixed costs
decease as production increases.
Total Fixed costs are (fixed) and therefore don’t
change when production increases but average fixed costs decrease
Fixed costs per unit (average fixed costs) will change as the
production/output changes.
U shaped Cost Curves (WHY?)
Diminishing Returns & the U Shape of the Curves – The Law of Diminishing
Returns states that as additional inputs are added to fixed capital, returns
will eventually decrease.
Initially the cost curves
are decreasing as more input is added reflecting efficiency, but as more inputs
are added costs increase as inputs become increasingly inefficient. Thus the rising cost curves with more output.
(Ex. If you have a coffee
cart out in front of the school and it is only big enough for two people.
Hiring one person will lower your average costs as you can actually produce a
good that will be sold. Hiring two people will allow a division of labor that
will increase your output. Hiring a third person will slow down the production
process as the coffee cart (fixed capital) isn’t big enough for three people to
operate effectively in the short run.)
Relationship between
Marginal Costs and Average Total Costs
·Marginal Cost curve cuts the ATC & AVC curves at their minimum
·When the MC curve is less than the ATC/AVC, ATC & AVC curves are
decreasing
·When the MC curve is greater than the ATC/AVC curves, the ATC/AVC are
increasing
·Marginal Cost curve eventually rise with increased output
·The ATC/AVC curves are U shaped due to the Law of Diminishing Returns
1995 AP Micro Exam
#6 Answer - C
The question asks for average total costs,
so, AFC + AVC = ATC
50 + 45 = 95
#7 Answer - D
Profit Max (MR = MC)
at output/quantity 5 the MC's are 80.00
if you produced 1 more unit, at a quantity of 6 you would be incurring a higher cost than the revenue brought in for that unit.
#8 Answer - A
An increase in wages (a variable cost) will shift the cost curves up. Understand that a shift implies at every level of output. A decrease in the price of energy would shift the curve down.
