COST OF PRODUCTION
AND THE RATE OF OUTPUT

How do a business firm’s costs vary with the amount it produces? Imagine a small company that produces a single product—say it assembles luxury-level hi-fl stereo sets. Suppose the company’s only costs are raw materials, labor, depreciation on plant and equipment, maintenance, and return on stockholders’ investment. Suppose further that, if we look at costs over the month ahead, we find that depreciation and a normal (implicit) return on stockholders’ investment are “fixed” for the month—they go on whether the company operates at full capacity or part capacity, or shuts down. The other costs are “variable,” depending on the company’s rate of output.

Assume that the “fixed” costs amount to $1,000 per month, and that the "‘variable” costs vary with changes in output as in Table 22-1.

These same costs are plotted in Fig. 22-1. Cost is shown on the vertical axis, output on the horizontal one. The fixed cost totals $1,000, the same no matter what output is produced. On top of this, we need to put total variable cost—zero at zero output, $2,000 for one set, $2,500 for two, and so on. The total-cost curve (top line) thus shows the sum of total fixed and total variable cost at each level of output.

FIG. 22-1 Total fixed cost is $1,000 at all outputs. Total variable cost rises as output increases. Total cost for any output is the sum of fixed and variable costs; it rises rapidly once the “capacity” of the plant is reached.

It is easy to see that total cost does not rise at an even rate. It doesn’t cost much more in total to produce two sets than one, or three than two. But as the firm gets up to six or seven sets per month, total cost begins to rise much more rapidly. It is obviously total variable cost that be- gins to shoot up. The reason may be that the company was set up with a capacity of only five or six sets a month, and to exceed this capacity in- volves expensive read justments in equipment, hir- ing more workers or overtime labor, and other such special problems. Or there may be some other explanation.