Supply: Production, Costs, and Profits - Essay Example

Constituents of Economic Costs Total Cost (TC): This is the sum of fixed cost and variable cost. Therefore; TC = FC + VC Fixed Costs (FC): These are costs associated with acquisition of fixed assets. They do not increase or reduce with the level of production. These include cost of purchasing land and machinery necessary for production to take place. Fixed cost is also referred to as total fixed cost (TFC) Variable Costs (TVC): These are costs which increase or decrease with the level of production.

These costs include costs of raw materials, wages and electricity costs and fuel costs among others. Average cost (AC): Average cost is also referred to as average fixed cost. It is calculated by dividing total cost with quantity of output, that is, TC/q where q is the quantity of output. Average cost can also be divided into two; average fixed cost and average variable cost. Average fixed cost (AFC) is calculated by dividing fixed cost by quantity of output. AFC reduces with increase in quantity of output.

Average variable cost (AVC) is derived from dividing variable cost with quantity of output. Average variable cost is depicted in a U-shaped curve. It has the same shape with the average cost curve but lies below the AC curve. Marginal Cost (MC): This is the cost of producing an additional unit of output. It is the change in total cost as a result of an increase in production by one unit. Its curve is also U-shaped. Marginal cost reduces with increase in production up to a point of cost minimization where an increase in production leads to an increase in MC (Boyes & Melvin, 2011). 2. Suppose a firm is operating at the minimum point of its short-run average total cost curve, so that marginal cost equals average total cost.

Under what circumstances would it choose to alter the size of its plant? Explain. A firm operating at the minimum point of its short-run average total cost curve, so that marginal cost equals average total cost, is at the points of tangency between the short-run average total cost curve and the long-run average total cost curve. These points can be seen in the diagram in red. Figure 1: SRATC’s and the LRATC (Source: Freeeconhelp.com) The long-run average total cost curve is demarked by the lowest points of every possible short-run average total cost curve (SRATC).

In the above diagram, the long-run average total cost curve is labeled as LRATC. When a firm is producing at the lowest level of SRATC1, the firm can only increase its plant size in order to increase its profitability. Increase in the plant size occurs in the long run. The firm should continue to increase its plant size up the point which it will be operating at the lowest level SRATC2. This is also the lowest point the LRATC. The firm will therefore be operating at constant returns to scale.

Constant returns to scale takes place when an equal percentage increase in all the factors of production leads to an equal percentage increase in output. Any level of production of output below the point of constant returns to scale occurs at economies of scale. Economies of scale take place when an equal percentage increase in all the factors of production leads to a greater percentage increase in output. When a firm is at this level, being bigger (increasing plant size) leads to higher efficiency and thus reduction in cost.

The firm should continue to increase its plant size up to the point where it attains constant returns to scale. If the firm increases its plant size above the level at