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Definition:

The entrepreneurs are no doubt interested in the total costs but they are equally concerned in knowing the average cost per unit of the product. The figures of average cost per unit can be derived from the total fixed cost, total variable cost and total cost by dividing each of them with corresponding output.

Types:

Average cost is divided into following three types:

  • Average fixed cost (AFC)
  • Average variable cost (AVC)
  • Average total cost (ATC)

(1) Average Fixed Cost (AFC):

Definition, Formula, Example and Diagram:

Average fixed cost (AFC) refers to fixed cost per unit of output. Average fixed cost is found out by dividing the total fixed cost by the corresponding output.

Average fixed cost is represented by the following formula:

For example, 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.

Average fixed cost (AFC) is now explained with the below diagram:

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):

Definition, Example, Formula and Diagram:

Average variable cost (AVC) 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 example, the total variable cost for producing 100 meters of cloth is $800, the average variable cost will be $8 per meter.

Average variable cost is represented by the following formula:

Behavior of Average Variable Cost (AVC):

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.

The average variable cost is now explained with the following diagram:

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):

Definition, Example, Formula and Diagram:

Average total cost (ATC) 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.

Average total cost (ATC) is represented by the following formula:

Behavior of Average Total Cost (ATC):

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.

The average total cost (ATC) is now explained with the following diagram:

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.