150 Reading: Sunk Costs and Alternative Measures of Cost
LESSONS FROM ALTERNATIVE MEASURES OF COSTS
Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm. Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit.
As explored in the section Choice in a World of Scarcity of the Introduction to Economics and Scarcity module, fixed costs are often sunk costs that cannot be recouped. In thinking about what to do next, sunk costs should typically be ignored, since this spending has already been made and cannot be changed. However, variable costs can be changed, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
Why are total cost and average cost not on the same graph?
Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced. These costs are measured in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, they are measured as cost per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since they are measured in different units ($ versus $ per unit of output).
It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. But the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives:
[latex]\displaystyle\text{average profit}=\frac{\text{profit}}{\text{quantity produced}}[/latex]
[latex]\displaystyle\text{average profit}=\frac{\text{total revenue}-\text{total cost}}{\text{quantity produced}}[/latex]
[latex]\displaystyle\text{average profit}=\frac{\text{total revenue}}{\text{quantity produced}}-\frac{\text{total cost}}{\text{quantity produced}}[/latex]
[latex]\displaystyle\text{average profit}=\text{average revenue}-\text{average cost}[/latex]
But note that:
[latex]\displaystyle\text{average revenue}=\frac{\text{price}\times\text{quantity produced}}{\text{quantity produced}}[/latex]
[latex]\displaystyle\text{average revenue}=\text{price}[/latex]
Thus:
[latex]\text{average profit}=\text{price}-\text{average cost}[/latex]
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative. The marginal cost of producing an additional unit can be compared with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how profits would be affected by increasing or decreasing production.
A VARIETY OF COST PATTERNS
The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an Internet company that provides medical advice to customers. Such a company might be paid by consumers directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients.
Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information.
In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine maintenance of the equipment, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other modules, we will analyze the firm’s cost structure from a long-run perspective.
Self Check: Sunk Costs
Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.
You’ll have more success on the Self Check if you’ve completed the Reading in this section.
Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.