average cost

Examples of average cost in the following topics:

• Average and Marginal Cost

  • The average cost is the total cost divided by the number of goods produced.
  • It is also equal to the sum of average variable costs and average fixed costs.
  • When the average cost declines, the marginal cost is less than the average cost.
  • When the average cost increases, the marginal cost is greater than the average cost.
  • When the average cost stays the same (is at a minimum or maximum), the marginal cost equals the average cost.

• The Law of Diminishing Returns

  • Average total cost is interpreted as the the cost of a typical unit of production.
  • Average total cost can also be graphed with quantity of output on the x axis and average cost on the y-axis.
  • What will this average total cost curve look like?
  • As long as the marginal cost of production is lower than the average total cost of production, the average cost is decreasing.
  • Average cost begins to increase where it intersects the marginal cost curve.

• Economic Costs

  • Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
  • Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q).
  • Average variable cost (AVC): variable costs divided by output (AVC = TVC/q).
  • The average variable cost curve is normally U-shaped.
  • It lies below the average cost curve, starting to the right of the y axis.

• Production Outputs

  • Average total cost is the all expenses incurred to produce the product, including fixed costs and opportunity costs, divided by the number of the units of the good produced.
  • Normal Profit: The average total cost equals the price at the profit-maximizing output.
  • Loss-minimizing condition: The firm's product price is between the average total cost and the average variable cost.
  • Shutdown: The price is below average variable cost at the profit-maximizing output.
  • It is not produced based on average total cost (ATC).

• Long Run Market Equilibrium

  • The long-run equilibrium of a perfectly competitive market occurs when marginal revenue equals marginal costs, which is also equal to average total costs.
  • So a firm will produce goods until the marginal costs of production equal the marginal revenues from sales.
  • In a perfectly competitive market, long-run equilibrium will occur when the marginal costs of production equal the average costs of production which also equals marginal revenue from selling the goods.
  • So the equilibrium will be set, graphically, at a three-way intersection between the demand, marginal cost and average total cost curves.
  • Firms can't make economic profit; the best they can do is break even so that their revenues equals their costs.

• Costs and Production in the Short-Run

  • Average Fixed Cost (AFC) is the FC divided by the output or TP, Q, (remember Q=TP).
  • AFC is fixed cost per Q.
  • Average Variable Cost (AVC) is the VC divided by the output, AVC = VC/Q.
  • It is the variable cost per Q.
  • Average Total Cost (AC or ATC) is the total cost per unit of output.

• Natural Monopolies

  • The total cost of the natural monopoly is lower than the sum of the total costs of two firms producing the same quantity .
  • Along with this, the average cost of production decreases and then increases.
  • In contrast, a natural monopoly will have a marginal cost that is constant or declining, and an average total cost that drops as the quantity of output increases.
  • Therefore, in industries with large initial investment requirements, average total costs decline as output increases.
  • The total cost of the natural monopoly's production is lower than the sum of the total costs of two firms producing the same quantity.

• Cost of capital

  • The cost of capital refers to the cost of the money used to pay for the capital.
  • Moreover, if a project contains a similar risk to a company's average business activities, then it is reasonable to use the company's average cost of capital as a basis for evaluating the success of investment .
  • In order to determine a company's cost of capital, the cost of debt and the cost of equity must be calculated.
  • One way of combining the cost of debt and equity to generate a single cost of capital number is through the weighted-average cost of capital (WACC).
  • The cost of capital is the cost of the money used to finance the plant.

• Shut Down Case

  • If a firm decreased production it would still acquire variable costs not covered by revenue as well as fixed costs (costs inevitably incurred).
  • Economic shutdown occurs within a firm when the marginal revenue is below average variable cost at the profit-maximizing output.
  • The shutdown rule states that "in the short run a firm should continue to operate if price exceeds average variable costs. "
  • If the revenue the firm is making is greater than the variable cost (R>VC) then the firm is covering it's variable costs and there is additional revenue to partially or entirely cover the fixed costs.
  • Firms will produce as long as marginal revenue (MR) is greater than average total cost (ATC), even if it is less than the variable, or marginal cost (MC)

• The Supply Curve in Perfect Competition

  • The total revenue-total cost perspective and the marginal revenue-marginal cost perspective are used to find profit maximizing quantities.
  • In economics, a cost curve is a graph that shows the costs of production as a function of total quantity produced.
  • In a free market economy, firms use cost curves to find the optimal point of production (minimizing cost).
  • The various types of cost curves include total, average, marginal curves.
  • There are two ways in which cost curves can be used to find profit maximizing quantities: the total revenue-total cost perspective and the marginal revenue-marginal cost perspective.