Costs:
Fixed, Variable and Sunk
One
of the important principles of economics is that the cost of something is what
you have to give up in order to get it. Let’s say that John McMan
is tired of working at his $2,500 accounting job and decided to run a business
to sell “Boba Drinks” to the public.
In
order to run the “Boba Drinks” business, he has to
give up his accounting job. Giving up
John’s income for his accounting job is what is called his opportunity cost—the
thing that he loses in order to create the business that he wants to run.
There are two types of costs that John is dealing with and they are called explicit cost and implicit cost. Explicit cost are inputs that require an outlay of money by the firm(Mankiw, pg. 269). John has to buy necessary materials such as cups and straws for the boba, boba machine maker, workers, a building to be rented, etc. Implicit costs are those that do not require the outlay of money by the firm (Mankiw, pg.269). John’s implicit cost is the income he could earn at the accounting firm, which he has to put into consideration.
The explicit cost of John McMan’s “Boba Drinks” business
can also be thought of as his Total Cost in creating and running the
business. By definition, total cost is
the amount of the entire inputs that John put into the business at market
value.
Table 8.d.1 John’s Boba Drink Table
which shows the relationship between the Quantity of drinks(Q) he can produce, the
Total cost(TC) of producing the prescribed quantity, and the Average Total Cost(ATC)
of producing one drink.
|
Qty. of
Boba Drinks sold |
Total
Cost($) |
Ave.
Total Cost(TC/Q) |
|
0.00 |
3.00 |
∞ |
|
1.00 |
3.50 |
3.50 |
|
2.00 |
4.00 |
2.00 |
|
3.00 |
4.70 |
1.57 |
|
4.00 |
5.60 |
1.40 |
|
5.00 |
6.70 |
1.34 |
|
6.00 |
8.00 |
1.33 |
|
7.00 |
9.50 |
1.36 |
|
8.00 |
11.20 |
1.40 |
|
9.00 |
13.10 |
1.46 |
|
10.00 |
15.20 |
1.52 |
Diagram
8.d.1 Illustrates
the relationship between Average Total Cost and Quantity of Boba
Drinks Sold. The ATC is a U-Shaped curve which shows that there is a minimum
point as the quantity of drinks produced rises. After reaching the minimum
point, it begins to curve upward which says that as the quantity produced gets
bigger, Total cost compounds and also gets bigger.
The business’ Total Cost can be divided into 2
different categories; Fixed Cost and Variable Cost.
Fixed Cost
Fixed
costs do not depend on the quantity of the goods the firm is selling. They are incurred even though the business
has not made any goods at all. In John McMan’s case, his fixed cost in the Boba
Drinks business includes the rent of the building he is going to use to run the
business, advertising expense, equipment expenses (i.e. blender, cups,
utensils), and others. John may also
hire workers needed to operate his business such as a cashier and a boba maker. This
will be included in the business’ salary expense.
Table
8.d.2 Boba Drinks’ Fixed Cost and
Average Fixed Cost
|
Qty. of
Boba Drinks |
Fixed
Cost |
Average
Fixed Cost |
|
0.00 |
3.00 |
∞ |
|
1.00 |
3.00 |
3.00 |
|
2.00 |
3.00 |
1.50 |
|
3.00 |
3.00 |
1.00 |
|
4.00 |
3.00 |
0.75 |
|
5.00 |
3.00 |
0.60 |
|
6.00 |
3.00 |
0.50 |
|
7.00 |
3.00 |
0.43 |
|
8.00 |
3.00 |
0.38 |
|
9.00 |
3.00 |
0.33 |
|
10.00 |
3.00 |
0.30 |
Diagram
8.d.2 Illustrates
the relationship between Average Fixed Cost (AVC) and Quantity(Q). As quantity produced gets bigger, Fixed cost curves downward because it is being distributed
to higher quantity.
Variable Costs
Variable
costs are costs that depend on the amount or quantity of the goods that are
being produced. The costs included in
this category are the supplies expense needed for the boba
drinks (i.e. cups, straws, ingredients).
The more she sells boba drinks, the higher the
variable costs being used. In addition,
the more popular and marketable the boba is to the
public, the more help John needs to create more bobas. Therefore, he has to hire more workers which increases the salary expenses incurred.
Table
8.d.3 Shown is the relationship between
the Quantity(Q), Variable Cost(VC) incurred and Average Variable Costs(AVC).
|
Qty. of
Boba Drinks |
Variable
Cost |
Ave.
Variable Cost |
|
0.00 |
0.00 |
∞ |
|
1.00 |
0.50 |
0.50 |
|
2.00 |
1.00 |
0.50 |
|
3.00 |
1.70 |
0.57 |
|
4.00 |
2.60 |
0.65 |
|
5.00 |
3.70 |
0.74 |
|
6.00 |
5.00 |
0.83 |
|
7.00 |
6.50 |
0.93 |
|
8.00 |
8.20 |
1.03 |
|
9.00 |
10.10 |
1.12 |
|
10.00 |
12.20 |
1.22 |
Diagram
8.d.3
Illustrates the relationship between Quantity and Average Variable Cost. This shows that as Quantity of drinks being
produced gets higher, Variable Cost also curves upward because one uses more
supplies to make the drinks which ultimately raises
the cost of production. This is the
opposite of Average Fixed Cost.
Diagram
8.d.4 Illustrates ATC, AFC and AVC together
in one graph.
Note that Average Total Cost equals the summation of
Average Variable Cost and Average Fixed Cost.
ATC
= AVC + AFC
In this case, it is easier to analyze relationships
between the averages of the Total, Variable and Fixed Costs because they
illustrate the Cost of a Boba drink at different
levels of production.
Sunk Cost
Sunk
costs are contracts and decisions that are already vouched and cannot be
recovered anymore. Compare to
opportunity costs where one has a decision of giving up something in order to
attain another thing, one has to live with sunk cost
because they are expenses that are permanent.
For example, if John noticed that it is not worth it to continue the Boba Drinks in the winter because people do not want to buy
cold drinks in icy weather, he may decide to shut down his business for the
winter season and reopen in the summer.
John’s fixed cost, which is the rent expense for the building can be
considered a sunk cost because he signed a lease to continue on paying rent for
the whole year. Sunk costs are ignored
and are irrelevant to the businessman when making decisions regarding his
business.