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Business must make decisions on whether to spend money now (fixed) or spend money later (variable)
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If a firm plans on producing a high amount of output, it might make sense to have a high fixed cost
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Conversely, if a firm plans on producing a small amount of output, it might make sense to have a low fixed cost
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Choosing the optimal level of fixed cost requires a lot of planning
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Meaning
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the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output
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If there are many possible choices of fixed cost, the long-run average total cost curve will have the familiar, smooth U shape.
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Graph
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Short-run and long-run average total cost curves differ because a firm can choose its fixed cost in the long run.
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If Selena has chosen the level of fixed cost that minimizes short-run average total cost at an output of 6 cases, and actually produces 6 cases, then she will be at point C on LRATC and ATC6.
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But if she produces only 3 cases, then she will move to point B.
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If she expects to produce only 3 cases for a long time, in the long run she will reduce her fixed cost and move to point A on ATC3.
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Likewise, if she produces 9 cases (putting her at point Y) and expects to continue this for a long time, she will increase her fixed cost in the long run and move to point X
- Example
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Economies of scale
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when long-run average total cost declines as input increases
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ATC decreases as Q increases
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Diseconomies of scale
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when long-run average total cost increases as output increases
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ATC increases as Q increases
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Graph
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Increased specialization that larger output levels allow
- a larger scale of operation means that workers are very specialized individuals
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Large initial set-up cost
- in auto manufacturing, electricity generating or petroleum refining, there exist high fixed costs to enter the industry
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Network externalities
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the effect that one user of a good or service has on the value of that product to other people
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When network effect it present, the value of a product or service if dependent on the number of others using it (ie. Telephone, Facebook, Twitter, eBay)
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Definition
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cost that should be ignored when making a decision
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A cost that has already happened that cannot be recovered
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As the old saying goes, "There's no use crying over spilled milk"
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Example
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You go to an All You Can Eat Brazilian BBQ Restaurant, pay $40 after eating a salad and you are full.
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What's the rational thing to do in order to get your money's worth?
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WALK OUT! SUNK COST!
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Marginal Benefit > Marginal Cost: Keep doing
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Marginal Cost > Marginal Benefit: Leave!
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