What is Average Cost (AC)
Average cost is the total cost of production divided by the quantity of output produced. It gives an indication of the cost per unit of output.
The average cost curve typically exhibits a U-shaped pattern. In the early stages of production, average costs are relatively high due to spreading fixed costs over a low level of output. As production increases, average costs tend to decrease due to economies of scale, efficient use of resources, and specialization.
However, beyond a certain point, the average cost may start to increase due to diseconomies of scale, resource constraints, or inefficiencies associated with larger-scale production.
Economies of scale occur when average costs decrease as production levels increase. This can result from bulk purchasing, efficient specialization of labor, and improved technology.
Diseconomies of scale occur when average costs increase as production levels increase. This can be due to increased complexity, communication challenges, and inefficiencies associated with larger operations.
Components of Average Cost
- Total Cost (TC): This is the sum of all costs incurred by a firm in the production process. It includes both fixed costs (which do not vary with the level of output) and variable costs (which change as the level of output changes).
- Fixed Cost (FC): These are costs that do not vary with the quantity of output produced. Examples include rent, salaries of permanent staff, and lease payments. Fixed costs are incurred even if the production level is zero.
- Variable Cost (VC): These are costs that vary in direct proportion to the quantity of output produced. Examples include raw materials, labor, and utilities. Variable costs increase as production levels increase.
- Average Fixed Cost (AFC): This is the fixed cost per unit of output and is calculated by dividing the total fixed cost by the quantity of output. Mathematically, AFC = FC / Quantity of Output.
- Average Variable Cost (AVC): This is the variable cost per unit of output and is calculated by dividing the total variable cost by the quantity of output. Mathematically, AVC = VC / Quantity of Output.
What is Marginal Cost (MC)?
Marginal cost is the additional cost incurred by producing one more unit of output. It represents the change in total cost when producing one additional unit. In a perfectly competitive market, where firms are price takers, profit maximization occurs where marginal cost equals the market price.
The relationship between average cost and marginal cost is crucial for understanding cost dynamics.
- When marginal cost is below average cost, it tends to pull average cost down.
- When marginal cost is above average cost, it tends to push average cost up.
- If marginal cost is equal to average cost, average cost remains constant.
In the short run, firms may produce at a level where marginal cost equals marginal revenue to maximize profit. In the long run, firms aim to produce at a level where average cost is minimized.
Pricing decisions are often influenced by both average cost and marginal cost. For example, in a competitive market, firms may set prices close to their average cost to remain competitive.
When a company knows both its marginal cost and marginal revenue for various product lines, it can concentrate resources towards items where the difference is the greatest. Instead of investing in minimally successful goods, it can focus on making individual units that maximum returns.
Average Cost vs Marginal Cost: Key Differences
|Total cost divided by the quantity of output produced.
|The additional cost incurred by producing one more unit of output.
|Reflects the average cost per unit over a specific level of output.
|Examines the cost of producing one additional unit at a particular level of output.
|Average Cost = Total Cost / Quantity of Output
|Marginal Cost = Change in Total Cost / Change in Quantity of Output
|Relationship to Output
|Represents a broad view over a range of output levels.
|Focuses on the immediate impact of producing one more unit.
|Used for making decisions about the overall production level.
|Useful for making decisions about producing an additional unit or not.
|Behavior at Optimal Output
|Average cost is at its minimum when marginal cost equals average cost.
|Marginal cost equals average cost at the minimum point of the average cost curve.
|Average cost tends to decrease initially and then increase due to economies and diseconomies of scale.
|Marginal cost initially decreases and then increases due to diminishing returns.
|Application in Pricing
|Used for setting the selling price to ensure profitability.
|Not typically used directly in pricing decisions, but influences production decisions.