Hints for Unit 7 Assignment

Some definitions to remember:

a. Fixed costs are the Total costs incurred even if NO items are manufactured.

b. Variable cost for that unit is the total cost for that unit minus the total cost of producing ZERO units.

c. Average variable cost for that unit is the variable cost for that number of units divided by the number of units.

d. Average total cost is the total costs for that number of units divided by the number of units.

e. Average fixed cost is the fixed cost when NO units are produced divided by the number of units produced.

f. The minimum-cost output is the number of units produced when the average total cost is the LOW EST.

g. Marginal cost is the total cost for a particular number or units minus the total cost for one LESS of the same number of units.

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The textbook states that “increasing output has two opposing effects on average total cost” (Krugman, 2017, p.333-335). The spreading effect (the effect of spreading the fixed costs over additional units) is one effect. The other effect is that of the diminishing

returns effect (the effect of increasing variable costs as the number of units increases). As more units are produced each additional unit’s share the FIXED costs gets smaller

and smaller, because we are spreading that FIXED cost over so many units (spreading effect).

As production is increased, there comes a level of production in which that share of the fixed costs is so small that it is drastically outweighed by the change in average VARIABLE costs, which, because of diminishing returns to labor (like our farming

example of adding more and more workers, but only increasing output by a little bit), causes the VARABLE costs to increase significantly.

As long as the share of FIXED costs is much smaller than the share of VARIABLE costs, we would see average total costs DECREASING.

At the level of production in which the next unit’s share of fixed costs is much smaller than its share of VARIABLE costs, we will see its average total costs begin to INCREASE.