Average Cost:
Definition and Explanation:
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in knowing
the cost per unit of the product. The unit cost figures can be derived from the total fixed cost, total variable
cost and total cost by dividing each of them with corresponding output.
Types/Classifications:
(1) Average Fixed Cost (AFC):
Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by dividing the
total fixed cost by the corresponding output.
Formula:
AFC = TFC
output (Q)
For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of shoes, then
the average fixed cost is equal to $10 per unit. If it produces 1,000 pairs of shoes, the average fixed cost
is $5 and if the total output is 5,000 pairs of shoes, then the average fixed cost is $1 pair of shoe.
From the above example, it is clear, that the fixed cost, i.e., $5,000 remains the same whether the output
is 1,000 or 5,000 units.
Behavior of Average Fixed Cost (AFC):
The average fixed cost begins to fall with the increase in the number of units produced, In our example
stated above, average fixed cost in the beginning was $10. As the output of the firm increased, it
gradually came down to $1. The AFC diminishes with every increase in the quantity of output produced
but it never becomes zero.
Diagram/Curve:
The concept of average fixed cost can be explained with the help of the curve, in the diagram (13.4) the
average fixed cost curve gradually falls from left to right showing the level of output. The larger the level
of output, the lower is the average fixed cost and smaller the level of output, the greater is the average
fixed cost. The AFC never becomes zero.
(2) Average Variable Cost (AVC):
Average variable cost refers to the variable expenses per unit of output Average variable cost is
obtained by dividing the total variable cost by the total output.
For instance, the total variable cost for producing 100 meters of cloth is $800, the average variable cost
will be $8 per meter.
Formula:
AVC = TVC
(Q)
Behavior of Average Variable Cost:
When a firm increases its output, the average variable cost decreases in the beginning, reaches a
minimum and then increases. Here, a question can be asked as to why AVC decreases in the beginning
reaches a minimum and then increases. The answer to this question is very simple.
When in the beginning, a firm is not producing to its full capacity, then the various factors of production
employed for the manufacture of a particular commodity remain partially absorbed. As the output of the
firm is increased, they are used to its fullest extent. So the AVC begins to decrease. When the plant
works to its full capacity, the AVC is at its minimum. If the production is pushed further from the plant
capacity, then less efficient machinery and less, efficient labour may have to be employed. This results in
the rise of AVC. It is in this way we say that as the output of a firm increases, the AVC decreases in the
beginning, reaches a minimum and then increases. The AVC can also be represented in the form of a
curve.
Diagram/Curve:
The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows that when
the output is increased, there is a steady fall in the average variable cost due to increasing returns to
variable factor. It is minimum when 500 meters of doth are produced. When production is increased to
600 meters, of cloth or more, the average variable cost begins to increase due to diminishing returns to
the variable factor.
(3) Average Total Cost (ATC):
Average total cost refers to cost (both fixed and variable) per unit of output. Average total cost is
obtained by dividing the total cost by the total number of commodities produced by the firm or when the
total sum of average variable cost and average fixed cost is added together, it becomes equal to average
total cost.
Formula:
ATC = Total Cost (TC)
Output (Q)
Behavior of Average Total Cost:
As the output of a firm increases, average total cost like the average variable cost decreases in the
beginning reaches a minimum and then it increases. The reasons for decline of ATC in the beginning are
that it is the sum of AFC and AVC.
Average fixed cost and average variable costs have both the tendency to fall as output is increased.
Average total cost will continue falling so long average variable cost does not rise. Even if average
variable cost continues rising, it is not necessary that the average total cost will rise. It can be due to the
fact that the increase in average variable cost is less than the fall in average fixed cost. The increase in
average variable cost is counterbalanced by a rapid fall of average fixed cost. If the rise in the average
variable cost is greater than the fall in average fixed cost, then the average total cost will rise.
The tendency to rise on the part of average total cost-in the beginning is slow, after a certain point it
begins to increase rapidly.
Diagram/Curve:
The average total cost is represented here by a shaped curve in Fig. (13.6). The average total cost curve
is also like a U-shaped curve. It shows that as production increases from 100 meters to 200 meters of
cloth, the cost falls rapidly, reaches a minimum but then with higher level of output, the average fixed cost
begins to increase.