Average cost

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In economics, average cost or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q):

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It is also equal to the sum of average variable costs (total variable costs divided by Q) and average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period considered (increasing production may be expensive or impossible number in the short term, for example). Average costs affect the supply curve and are a fundamental component of supply and demand.

Short-run average cost

A U-shaped short-run Average Cost (AC) curve. AVC is the Average Variable Cost, AFC the Average Fixed Cost, and MC the marginal cost curve crossing the minimum points of both the Average Variable Cost and Average Cost curves. Shortruncostcurves.jpg
A U-shaped short-run Average Cost (AC) curve. AVC is the Average Variable Cost, AFC the Average Fixed Cost, and MC the marginal cost curve crossing the minimum points of both the Average Variable Cost and Average Cost curves.

Short-run costs are those that vary with almost no time lagging. Labor cost and the cost of raw materials are short-run costs, but physical capital is not.

An average cost curve can be plotted with cost on the vertical axis and quantity on the horizontal axis. Marginal costs are often also shown on these graphs, with marginal cost representing the cost of the last unit produced at each point; marginal costs in the short run are the slope of the variable cost curve (and hence the first derivative of variable cost).

A typical average cost curve has a U-shape, because fixed costs are all incurred before any production takes place and marginal costs are typically increasing, because of diminishing marginal productivity. In this "typical" case, for low levels of production marginal costs are below average costs, so average costs are decreasing as quantity increases. An increasing marginal cost curve intersects a U-shaped average cost curve at the latter's minimum, after which the average cost curve begins to slope upward. For further increases in production beyond this minimum, marginal cost is above average costs, so average costs are increasing as quantity increases. For example: for a factory designed to produce a specific quantity of widgets per period—below a certain production level, average cost is higher due to under-used equipment, and above that level, production bottlenecks increase average cost.

Long-run average cost

Long-run average cost is the unit cost of producing a certain output when all inputs, even physical capital, are variable. The behavioral assumption is that the firm will choose that combination of inputs that produce the desired quantity at the lowest possible cost.

A long-run average cost curve is typically downward sloping at relatively low levels of output and upward or downward sloping at relatively high levels of output. Most commonly, the long-run average cost curve is U-shaped, by definition reflecting economies of scale where negatively sloped and diseconomies of scale where positively sloped.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown [1] [2] [3] that at a particular level of output, the firm has economies of scale (i.e., is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale, the latter being exclusively a feature of the production function. Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. With perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

In some industries, long-run average cost is always declining (economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.

Relationship to marginal cost

When average cost is declining as output increases, marginal cost is less than average cost. When average cost is rising, marginal cost is greater than average cost. When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost.

Other special cases for average cost and marginal cost appear frequently:

Relationship between AC, AFC, AVC and MC

1. The Average Fixed Cost curve (AFC) starts from a height and goes on declining continuously as production increases.

2. The Average Variable Cost curve, Average Cost curve and the Marginal Cost curve start from a height, reach the minimum points, then rise sharply and continuously.

3. The Average Fixed Cost curve approaches zero asymptotically. The Average Variable Cost curve is never parallel to or as high as the Average Cost curve due to the existence of positive Average Fixed Costs at all levels of production; but the Average Variable Cost curve asymptotically approaches the Average Cost curve from below.

4. The Marginal Cost curve always passes through the minimum points of the Average Variable Cost and Average Cost curves, though the Average Variable Cost curve attains the minimum point prior to that of the Average Cost curve.

See also

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Production function physical output of a production process to physical inputs or factors of production

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Marginal product

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Total cost

In economics, total cost (TC) is the total economic cost of production and is made up of variable cost, which varies according to the quantity of a good produced and includes inputs such as labour and raw materials, plus fixed cost, which is independent of the quantity of a good produced and includes inputs that cannot be varied in the short term: fixed costs such as buildings and machinery, including sunk costs if any. Since cost is measured per unit of time, it is a flow variable.

In economics the long run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long run contrasts with the short run, in which there are some constraints and markets are not fully in equilibrium.

Supply (economics) in economics, the amount of a good that sellers are willing to provide in the market

In economics, supply is the amount of a resource that firms, producers, labourers, providers of financial assets, or other economic agents are willing and able to provide to the marketplace or directly to another agent in the marketplace. Supply can be in currency, time, raw materials, or any other scarce or valuable object that can be provided to another agent. This is often fairly abstract. For example in the case of time, supply is not transferred to one agent from another, but one agent may offer some other resource in exchange for the first spending time doing something. Supply is often plotted graphically as a supply curve, with the quantity provided plotted horizontally and the price plotted vertically.

A firm will choose to implement a shutdown of production when the revenue received from the sale of the goods or services produced cannot even cover the variable costs of production. In that situation, the firm will experience a higher loss when it produces, compared to not producing at all.

In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. It is a feature of the production function, and depends on the amounts of physical capital and labor already in use.

Socially optimal firm size

The socially optimal firm size is the size for a company in a given industry at a given time which results in the lowest production costs per unit of output.

References

  1. Gelles, Gregory M., and Mitchell, Douglas W., "Returns to scale and economies of scale: Further observations," Journal of Economic Education 27, Summer 1996, 259-261.
  2. Frisch, R., Theory of Production, Dordrecht: D. Reidel, 1965.
  3. Ferguson, C. E., The Neoclassical Theory of Production and Distribution, London: Cambridge University Press, 1969.