What are the two components of a firm’s average costs of production, how do they change...

What are the two components of a firm’s average costs of production, how do they change as output increases? What is the shape of a typical firm’s average cost curve given this? Draw a diagram and explain.

Expert Solution

The average cost of production is the summation of the average variable cost of production and average fixed cost of production. That is we can write as

ATC (Average total cost) = AFC (Average fixed cost) + AVC (Average variable cost)

The average variable cost equals the variable cost divided by output. AVC = VC/Q. The variable cost is the cost that varies with the level of output. That is, variable cost increases/ decreases with an increase/decrease in the level of output. If the output is zero, then the variable cost will also be zero. The average variable cost curve is U shaped and is cut by marginal cost at its minimum.

The average fixed cost equals the fixed cost divided by output. AFC = FC/Q. The variable cost is the cost that do not vary with the level of output. That is, fixed cost do not increase/ decrease with an increase/decrease in the level of output. If the output is zero, then the variable cost will NOT be zero. The fixed cost are constant and same throughout in the short run. The average fixed cost curve is downward sloping and rectangular hyperbola shaped. The AFC keeps on falling as the output increases.

The ATC curve us U shaped as the AVC curve due to application of law of returns to a factor in the short run and law of returns to scale in the long run which states that as more and more inputs are employed there will be a stage when marginal product will start declining and even become negative. in the increasing returns stage the average cost curve is falling and in the constant returns it rebounds and starts increasing in the third stage when marginal product starts to fall.

Rahul Sunny answered 1 year ago

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