Average cost

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In economics, average cost (AC) or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q):

Average cost is an important factor in determining how businesses will choose to price their products.

Short-run average cost

  Average cost (AC) curve
  Marginal cost (MC; crosses the minimum points of both the AC and AFC curves)

Short-run costs are those that vary with almost no time lagging.

raw materials are short-run costs, but physical capital
is not.

An

first derivative
of variable cost).

A typical average cost curve has a U-shape, because

bottlenecks
increase average cost.

Long-run average cost

Long-run average cost is the unit cost of producing a certain output when all inputs, even physical capital, are variable. The behavioral assumption is that the firm will choose that combination of inputs that produce the desired quantity at the lowest possible cost.

A long-run average cost curve is typically downward sloping at relatively low levels of output, and upward or downward sloping at relatively high levels of output. Most commonly, the long-run average cost curve is U-shaped, by definition reflecting economies of scale where negatively sloped and diseconomies of scale where positively sloped.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown[1][2][3] that at a particular level of output, the firm has economies of scale (i.e., is operating in a downward sloping region of the long-run average cost curve) if and only if it has increasing returns to scale, the latter being exclusively a feature of the production function. Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-run average cost curve) if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. With perfect competition in the output market the long-run market equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

In some industries, long-run average cost is always declining (economies of scale exist indefinitely). This means that the largest firm tends to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs, such as water supply and electricity supply.

Relationship to marginal cost

When average cost is declining as output increases, marginal cost is less than average cost. When average cost is rising, marginal cost is greater than average cost. When average cost is neither rising nor falling (at a minimum or maximum), marginal cost equals average cost.

Other special cases for average cost and marginal cost appear frequently:

  • Constant marginal cost/high
    barrier to entry
    .
  • Two popular pricing mechanisms are average cost pricing (or rate of return regulation) and marginal cost pricing. A monopoly produces where its average cost curve meets the market demand curve under average cost pricing, referred to as the average cost pricing equilibrium.
  • elasticity of supply
    are higher, as new plants could be built and brought on-line.
  • Zero fixed costs (long-run analysis) and constant marginal cost: since there are no economies of scale, average cost is equal to the constant marginal cost.

Relationship between AC, AFC, AVC and MC

1. The Average Fixed Cost curve (AFC) starts from a height and goes on declining continuously as production increases.

2. The Average Variable Cost curve, Average Cost curve and the Marginal Cost curve start from a height, reach the minimum points, then rise sharply and continuously.

3. The Average Fixed Cost curve approaches zero asymptotically. The Average Variable Cost curve is never parallel to or as high as the Average Cost curve due to the existence of positive Average Fixed Costs at all levels of production; but the Average Variable Cost curve asymptotically approaches the Average Cost curve from below.

4. The Marginal Cost curve always passes through the minimum points of the Average Variable Cost and Average Cost curves, though the Average Variable Cost curve attains the minimum point prior to that of the Average Cost curve.

See also

References

  1. ^ Gelles, Gregory M., and Mitchell, Douglas W., "Returns to scale and economies of scale: Further observations," Journal of Economic Education 27, Summer 1996, 259-261.
  2. ^ Frisch, R., Theory of Production, Dordrecht: D. Reidel, 1965.
  3. ^ Ferguson, C. E., The Neoclassical Theory of Production and Distribution, London: Cambridge University Press, 1969.

External links