Question

why average cost is u-shaped curve?

Answer 1

When we add fixed and variable cost we get total cost and when we divide it by the quantity produced we get the average total cost.

Now this curve is U shaped.

Let's try to understand it with the help of an example. Suppose we start a textile factory, then the land we buy and machinery we put will be the fixed cost of the firm. Now, in order to start production we will hire labour to run the machinery of the factory. This will be included in variable cost.

Now initially the average total cost will be high because there is a lot of fixed cost and variable cost is involved in it already and quantity produced is less. But with the increase in production, average fixed cost will decrease cause it is constant and divided by higher and higher quantity.

Secondly, as the firm will start producing more and more, the average variable cost will fall because of increasing return to scale. More the labour we will invest more our fixed machinery and land will be used resulting in decreased per unit cost of production, hence, decrease in average variable cost. Which will result in decrease in average total cost.

Now, this scenario will not continue forever, even though average fixed cost will decrease forever, average variable cost will come to a minimum point and then will start increasing again, because initially employing more, labour, was increasing our production but if we will keep on increasing labour on the machinery, then we must notice machinery is fixed and after a specific amount of labour used on machinery it will be useless to hire anymore and thus we will start incurring larger per unit cost of production. Which will result as increase in average variable cost. Which will result as increase in average total cost.

Thus the average total cost curve is U shaped