I already have given enough information at hand about governance costs in the short-run context to proceed on to the analysis in the previous sections. We shall take up the nature of overhead or fixed governance costs in this section, but I run the risk of conveying a misimpression to the reader about the significance of fixed governance costs to short-run decision making. So, at the outset of this discussion we repeat our assertion from an earlier section of this series that overhead governance costs are “sunk and gone,” and are thus governance costs which are not relevant to short-run production decision making. I shall be examining the nature of fixed governance costs in the short-run context purely for information, and not as prospective decision criteria.
Overhead governance costs, usually fixed by contractual obligation at the same level as long as the existing plant, equipment, and management are intact; can be illustrated as a horizontal line TFC, at the altitude of the total of the fixed governance costs. Then, to the fixed governance costs can be added the total variable governance cost at each level of output to measure the total governance cost, represented by curve TC. It should be apparent that the TC curve lies above the TVC curve by a constant vertical distance (the magnitude of TFC), and that the two curves are parallel to each other along verticals. This means that along any vertical which crosses both curves, a tangent to either curve will be parallel to a tangent to the other curve. The significance of this relationship lies in the fact that a common MC curve and serves both the TC and TVC curves.
The same methodology, i.e., drawing rays from the origin to points along the total curve, can be used to ascertain the behavior of the average fixed governance cost, AFC, which can be computed as
AFC = TFC/Q.
In similar fashion to finding the position of the TC curve by adding TVC to TFC, the locus of the average total governance cost curve, ATC, by vertically summing the AVC and AFC curves. The reader should confirm that any level of output the ATC curve lies above the AVC curve by the amount of the average fixed governance cost at that output level, which is also the altitude of the AFC curve. It may also be noted in passing that the MC curve passes through the minimum point of the ATC as well as the minimum point of the AVC curve, but that the minimum of the ATC lies somewhat to the right of the minimum of the AVC. This latter relationship is true the tangency of the ray from the origin to the TC curve occurs to the right of the tangency of the ray from the origin to the TVC curve.
The TC and TVC curves appear to converge toward the upper end. However, they do so only in the horizontal dimension; the vertical distance between them is maintained constant. The ATC and AVC curves do tend to converge in both the horizontal and vertical dimensions because of the spreading of the overhead as Q increases.
To return to the caution issued at the beginning of this section, what are the short-run significances of the TFC, the TC, the AFC, and the ATC curves constructed upon recognition of the overhead governance costs? Before the making of short-run output and pricing decisions, they should be ignored as irrelevant governance costs; after the point of decision, they may be regarded purely as information to be considered in any forth-coming long-run decision set. Particularly, the decision maker should not attempt to set price to cover overhead governance costs or total governance costs (including overhead); the output decision should not be oriented specifically toward the spreading of the overhead.
The criteria for appropriate pricing and output decisions are developed in through the coming posts. After the fact of selecting the price and output upon appropriate criteria, the manager may in retrospect observe whether or not total governance costs were covered, and by how much the overhead was spread across the number of units produced. If the total governance costs were not covered, or the overhead governance costs were not met, then a long-run change may be warranted.