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Studying for a test? Prepare with these 5 lessons on Production decisions and economic profit.
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Voiceover: What I want to do in this video is think about a fairly traditional business. I am going into the orange juice business. Right over here, I've written the gallons of orange juice I am going to produce each week, so all of this is going to be in a per week basis. This is my fixed cost, so I'm assuming this is going to cost me $1,000, and let's say that that's the rent for this super robotic orange juicer that I bought that can really, and through that for the sake of simplicity, we're assuming that we can put as much orange juice as we want, or at least any of the amounts that I've listed right over here, and it also takes into the cost of maybe some employees who are spending some of their time operating this super orange juice mixer. I'm assuming all of those are fixed cost, and I can't get out of them or buy them overnight, that I've decided, I've plunked down the cost for the machine, and I've given these employees, let's say I've given them already a one-year contract. These are going to be fixed, at least for the next year. Now, my variable costs, here, these are going to be given the amount of juice I want to produce. This is going to be the cost of the oranges, and I guess we can also say the cost of transporting the oranges, and so we see here, obviously if we produce no oranges, we have no variable cost. If we produce 1,000 oranges, then our cost of the oranges and transporting them is $500. If we produce 2,000, it's 850, and something interesting happened. Our incremental variable cost right over here was only $350. The first 1,000 oranges was 500, and then the next 1,000, it was only 350. So what's happening here is I've probably got some economies ... I've probably got some negotiating power now with some of these suppliers. I'm like, "Look, I'm buying a lot more oranges now. "Let me negotiate the price down," and also maybe with some of the people who are doing my shipping, my transportation. "Look, I'm shipping a lot. "Now, why don't you give me a better deal?" We see the deal got even better. The incremental from this to this is only 250. Then it starts getting more expensive again. What's probably happening is, as I start buying more and more oranges from the local distributors, I get a better, better deal. They view me as a bigger and bigger customer, but once I tap them out, then I have to go further and further away. Maybe it's costing more to transport them, or maybe these other suppliers don't take me as seriously or I go to slightly more expensive suppliers because I've tapped out all of the cheap ones, and so my incremental variable costs for the next 1,000, and we'll think about that later, keeps going up and up and up. The total costs, obviously, are just the sum of my fixed costs and my variable costs. So, if I want to produce 9,000 gallons of orange juice, it's going to cost me $4,360. Let's calculate using, and I'm just using Excel, here. Let's calculate the average fixed cost, so we don't want to divide by zero. Remember, the average cost, the average fixed and the average variable and the average total cost, these are each of those costs divided by the total amount of juice that I'm producing. You can kind of view them as the cost per gallon. So that we're thinking of the average fixed cost per gallon, so what we're going to do, so I'm writing equal to let Excel know that I'm doing a formula now, this is going to be equal to my fixed cost divided by, so divided by, divided by my gallons, and you can see that's G8 divided by F8, and actually, I guess you can't see my Gs and Fs, but this is the 8th row. That's that right over there, so that is $1. If I want my average variable costs, that's going to be my variable costs divided by, divided by my total number of gallons, so that's 50 cents, so that's the first 1,000 gallons to produce the orange juice, the orange juice for ... to produce a gallon, it costs me about 50 cents worth of oranges. That includes the transportation cost. Then the total is just the sum of these two things. Or, we could have done it another way. We could have taken this right ... We could have said that this is just equal to, this is just equal to our total cost, our total cost divided by the total number of gallons. Either way, you'll get the same thing, and maybe I'll do a video mathematically on why that is, or maybe you should explore that yourself. Now, the marginal cost. This is equal to our change in cost, our change in total cost divided by our change in gallons of juice. Our change in total costs is going to be 1,500 minus 1,000. That's our change in total cost divided by our change in gallons, divided by 1,000 minus 0, our change in gallons, and that give us 50 cents. Now, this is the fun thing about spreadsheets, one of the many fun things of spreadsheets, is now I can select all of these and fill in all of the things below it. They will use the same relative calculations. Let me just ... I'm going to fill without formatting. Now, what was neat here, and I already set up this chart ahead of time, is to plot these things right over here, and so we see what's going on. This is a plot that we looked at in the last video, when we thought about software developers. This was our fixed cost, our variable costs go up as we produce more and more. Our total cost is just a sum of the two, so you just take your variable costs, and you add the $1,000 from the fixed costs, and you get this curve right over here. What we've done here is we've plotted all of this stuff. The average fixed costs, or actually the marginal costs, the average variable costs and the average total costs. I haven't plotted the average fixed cost here, but it's really just the difference between the total and the variable costs. Now, let's think about what's happening. First, let's look at the average, the marginal. Actually, let's look at the marginal costs first, because this is interesting, and this kind of goes in with this narrative of at first, those first oranges that we bought were expensive. We weren't a major producer, but incrementally, incrementally, as we produce those next oranges, so as we go from 1,000 oranges, as we go from the oranges needed for 1,000 gallons to the oranges needed for 2,000 gallons, all of a sudden, our marginal cost went down. We're now a bigger buyer. We can now, those incremental oranges are now cheaper to us. As we get even more, as we go to 3,000 gallons worth of oranges, those incremental oranges get even cheaper for us. Then we have to go and buy oranges from the outside, so those incremental oranges get more and more and more and more expensive. That's most clear in this marginal cost curve, and it's somewhat clear in the average, the average variable cost. In the average variable cost, it gets muffled to a certain degree, because remember the average variable cost at any one of these points, and we calculated it already several times. The average variable cost at any of these points is equal to, is equal to your variable costs divided by the gallons of juice. So another way to think about it, referring to the last video, if you're taking any one of these points, your average variable cost is the slope between that point and the origin, while the marginal cost is the slope between that point and the previous point, so the marginal cost is really showing how much are those next incremental oranges costing you, not just how much are all of the oranges on average costing you. That's why the marginal cost curve captures, captures how much those that very next set of 1,000 gallons worth of oranges, how much that is costing you. Obviously, your average total cost, at first you have your fixed cost, aren't being spread out too much, but then as you get more and more gallons of orange juice produced, your fixed cost gets spread out more and more and more, and so you actually have this gap, this gap between the green curve and the orange curve, which is really just your average fixed cost. That becomes lower and lower and lower.