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.
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