Economics Short Run Vs Long Run Costs Questions Long
Average cost is a measure of the cost per unit of output produced by a firm. It is calculated by dividing the total cost of production by the quantity of output. Average cost can be further divided into two components: average fixed cost (AFC) and average variable cost (AVC).
Average fixed cost (AFC) is the fixed cost per unit of output and decreases as the quantity of output increases. This is because fixed costs, such as rent and insurance, are spread over a larger number of units as production increases. Therefore, AFC decreases as the firm achieves economies of scale.
Average variable cost (AVC) is the variable cost per unit of output and tends to decrease initially and then increase as the quantity of output increases. Initially, AVC decreases due to economies of scale and specialization. However, as the firm reaches its capacity limits, AVC starts to increase due to diminishing returns to variable inputs.
The relationship between average cost and marginal cost is crucial in understanding the cost structure of a firm. Marginal cost (MC) refers to the additional cost incurred by producing one more unit of output. It is calculated by dividing the change in total cost by the change in quantity of output.
The relationship between average cost and marginal cost can be summarized as follows:
1. When marginal cost is below average cost: In this scenario, producing an additional unit of output adds less to the total cost than the average cost per unit. As a result, the average cost decreases. This occurs when marginal cost is lower than the average cost, pulling it down.
2. When marginal cost is equal to average cost: When marginal cost equals average cost, the average cost remains constant. This implies that the additional unit of output adds the same amount to the total cost as the average cost per unit.
3. When marginal cost is above average cost: In this case, producing an additional unit of output adds more to the total cost than the average cost per unit. As a result, the average cost increases. This occurs when marginal cost is higher than the average cost, pushing it up.
The relationship between average cost and marginal cost is crucial for firms to make production decisions. If marginal cost is below average cost, it is beneficial for the firm to increase production as it reduces the average cost. Conversely, if marginal cost is above average cost, it is advisable for the firm to decrease production to lower the average cost.
In summary, average cost represents the cost per unit of output, while marginal cost represents the additional cost incurred by producing one more unit. The relationship between the two helps firms understand the cost structure and make optimal production decisions.