Introductory Economics

Types of Cost

Average Total Cost (ATC):

• Average total cost refers to the average of all costs per unit of output i.e.,

ATC = AFC + AVC
or

• Average total cost (ATC) or average cost (AC) is also known as unit cost, since it is the cost per unit of output produced (Fig. 8). ATC or AC reaches at a low point but at a higher output than AVC curve. The AC falls over a greater range of output than AVC because of the flattening/ lowering influence of AFC. For a range beyond the minimum of AVC curve, AFC falls at a faster rate than the increase in AVC and this causes AC to continue to fall beyond the minimum of AVC curve. The ATC curve starts rising when the rate of decrease of AFC curve is less than the rate of increase of AVC curve.

Marginal Cost (MC):

• Marginal cost (MC) (Fig. 9) is the cost of producing an additional unit of output.

Marginal cost is independent of fixed cost.
MCn = TCn – TCn-1 or
= (TVCn + TFCn) - (TVCn-1 + TFCn-1)
or
= TVCn – TVCn-1
(Because TFCn and TFCn-1 are same as the fixed cost is constant
Hence marginal cost is the addition to the total variable cost when output is increased from ‘n-1’ units to ‘n’ units of output. Marginal cost is inversely related to marginal product (MP) of the variable input (Fig. 10).

Mathematically,

TYPICAL AVERAGE AND MARGINAL COST CURVES AND THEIR SELECTED ATRIBUTES

• AFC is always declining at a decreasing rate.
• ATC and AVC decline at first, reach a minimum, and then increase at higher levels of output.
• The difference between ATC and AVC is equal to AFC.
• MC crosses ATC and AVC at their minimum points.
• If MC is below the average cost value; Average cost value will be decreasing.
• If MC is above the average cost value; Average cost value will be increasing.

RELATIONSHIP BETWEEN AVERAGE AND MARGINAL COST

If MC < AC, then AC is falling
If MC > AC, then AC is rising
If MC = AC, then AC is constant

Mathematically, these relationships can be worked out as follow:

PRODUCTION RULES FOR THE SHORT RUN
Case 1:

• If expected selling price > minimum ATC (which implies total revenue (TR) > TC): A profit can be made.
• Maximize profit by producing where,

MR = MC

Case 2:
If expected selling price < minimum ATC but > minimum AVC: (Which implies TR > TVC but < TC), then;

• A loss cannot be avoided.
• Minimize loss by producing where,

MR = MC

Case 3:
If expected selling price < minimum AVC (which implies TR < TVC) then;

• A loss cannot be avoided.
• Minimize loss by not producing.
• The loss will be equal to total fixed cost (TFC).