U-shaped average cost curve

The shape that average cost curves are believed to take. The argument is that any
productive process has some overheads or fixed costs; these ensure that at low levels of
output average cost is high. There are bound to be some inputs which cannot be increased
indefinitely, at least in the short run. When output is high, shortages of these restrict the
efficiency with which such inputs as can be varied contribute to more output. Thus at
high levels of output marginal costs tend to be high, leading to increasing average costs.
At some medium level or possibly range of output, average costs reach a minimum,
hence the name. Whether long-run average cost curves must turn up or could remain flat
for ever is a matter of some dispute.

In economics, average cost is equal to total cost divided by the number of goods
produced (the output quantity, Q). It is also equal to the sum of average variable costs
(total variable costs divided by Q) plus average fixed costs (total fixed costs divided by
Q). Average costs may be dependent on the time period considered (increasing
production may be expensive or impossible in the short term, for example). Average
costs affect the supply curve and are a fundamental component of supply and demand.

Contents
[hide]

• 1 Short-run average cost

• 2 Long-run average cost
• 3 Relationship to marginal cost
• 4 Relationship between AC, AFC, AVC and MC
• 5 See also
• 6 References

• 7 External links

[edit] Short-run average cost

Average cost is distinct from the price, and depends on the interaction with demand
through elasticity of demand and elasticity of supply. In cases of perfect competition,
price may be lower than average cost due to marginal cost pricing.

Short-run average cost will vary in relation to the quantity produced unless fixed costs are
zero and variable costs constant. A cost curve can be plotted, with cost on the y-axis and
quantity on the x-axis. Marginal costs are often shown on these graphs, with marginal
cost representing the cost of the last unit produced at each point; marginal costs are the
first derivative of total or variable costs.

A typical average cost curve will have a U-shape, because fixed costs are all incurred
before any production takes place and marginal costs are typically increasing, because of
diminishing marginal productivity. In this "typical" case, for low levels of production
marginal costs are below average costs, so average costs are decreasing as quantity
increases. An increasing marginal cost curve will intersect a U-shaped average cost curve
at its minimum, after which point the average cost curve begins to slope upward. For
further increases in production beyond this minimum, marginal cost is above average
costs, so average costs are increasing as quantity increases. An example of this typical
case would be a factory designed to produce a specific quantity of widgets per period:
below a certain production level, average cost is higher due to under-utilised equipment,
while above that level, production bottlenecks increase the average cost.

[edit] Long-run average cost

The long run is a time frame in which the firm can vary the quantities used of all inputs,
even physical capital. A long-run average cost curve can be upward sloping, downward
sloping, or downward sloping at relatively low levels of output and upward sloping at
relatively high levels of output, with an in-between level of output at which the slope of
long-run average cost is zero. The typical 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. 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. In this case, 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, the LRAC 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.

[edit] 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 fixed costs: each additional unit of production is

produced at constant additional expense per unit. The average cost curve slopes
down continuously, approaching marginal cost. An example may be hydroelectric
generation, which has no fuel expense, limited maintenance expenses and a high
up-front fixed cost (ignoring irregular maintenance costs or useful lifespan).
Industries where fixed marginal costs obtain, such as electrical transmission
networks, may meet the conditions for a natural monopoly, because once capacity
is built, the marginal cost to the incumbent of serving an additional customer is
always lower than the average cost for a potential competitor. The high fixed
capital costs are a barrier to entry.
• Minimum efficient scale / maximum efficient scale: marginal or average costs
may be non-linear, or have discontinuities. Average cost curves may therefore
only be shown over a limited scale of production for a given technology. For
example, a nuclear plant would be extremely inefficient (very high average cost)
for production in small quantities; similarly, its maximum output for any given
time period may essentially be fixed, and production above that level may be
technically impossible, dangerous or extremely costly. The long run elasticity of
supply will be higher, as new plants could be built and brought on-line.
• Zero fixed costs (long-run analysis) / constant marginal cost: since there are no
economies of scale, average cost will be equal to the constant marginal cost.

[edit] Relationship between AC, AFC, AVC and MC

1. The Average Fixed Cost curve 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.

U-SHAPED COST CURVES:

The family of short-run cost curves consisting of average total cost, average variable
cost, and marginal cost, all of which have U-shapes. Each is U-shaped because it
begins with relatively high but falling cost for small quantities of output, reaches a
minimum value, then has rising cost at large quantities of output. Although the
average fixed cost curve is not U-shaped, it is occasionally included with the other
three just for sake of completeness.
The U-shapes of the average total cost, average variable cost, and marginal cost curves
are directly or indirectly the result of increasing marginal returns for small quantities
of output (production Stage I) followed by decreasing marginal returns for larger
quantities of output (production Stage II). The decreasing marginal returns in Stage
II result from the law of diminishing marginal returns.

The U-shaped cost curves form the foundation U-Shaped Cost Curves
for the analysis of short-run, profit-maximizing
production by a firm. These three curves can
provide all of the information needed about the
cost side of a firm's operation.

Bring on the Curves

The diagram to the right displays the three
U-shaped cost curves--average total cost
curve (ATC), average variable cost curve
(AVC), and marginal cost curve (MC)--for the
production of Wacky Willy Stuffed Amigos
(those cute and cuddly snakes, armadillos,
and turtles).

All three curves presented in this diagram are U-shaped. In particular, the production of
Wacky Willy Stuffed Amigos, like other goods, is guided by increasing marginal returns
for relatively small output quantities, then decreasing marginal returns for larger
quantities.

Consider a few reference points:

• The marginal cost curve reaches its minimum value at 4 Stuffed Amigos.
 • The average variable cost curve reaches its minimum at 6 Stuffed Amigos.
• The average total cost curve reaches its minimum at 6.5 Stuffed Amigos.

The marginal cost curve for Stuffed Amigos production is the only one of these three
curves that is DIRECTLY affected by the law of diminishing marginal returns. Up to a
production of 4 Stuffed Amigos, increasing marginal returns is in effect. From the 5th
Stuffed Amigo on, decreasing marginal returns (and the law of diminishing marginal
returns) takes over. The U-shaped pattern for the marginal cost curve that results
from increasing and decreasing marginal returns is then indirectly responsible for
creating the U-shape of the average variable cost and average total cost curves.

The Average-Marginal Relation

The average total cost, average variable cost, and marginal cost curves depict the
basic mathematical relation that exists between any average and the corresponding
marginal.

• Average Variable Cost: First, note the relation between the average variable
cost curve and the marginal cost curve. The marginal cost curve intersects
the average variable cost curve at its minimum value. Moreover, when
average variable cost is declining (the average variable cost curve is
negatively sloped), marginal cost is less than average variable cost. And when
average variable cost is rising (the average variable cost curve is positively
sloped), marginal cost is greater than average variable cost.
• Average Total Cost: Second, the average-marginal relation is also seen with
the average total cost curve. The marginal cost curve intersects the average
total cost curve at its minimum value, as well. When average total cost is
declining (the average total cost curve is negatively sloped), marginal cost is
less than average total cost. When average total cost is rising (the average
total cost curve is positively sloped), marginal cost is greater than average
total cost.

Note that the minimum values of the average total cost curve and the average
variable cost curve occur at different quantities. This results because: (1) marginal
cost intersects each average curve at its minimum value, (2) the marginal cost curve
has a positive slope, and (3) there is a gap between the two average curves, which is
average fixed cost. As such, the marginal cost intersects the minimum of the average
variable cost curve at 6 Stuffed Amigos, then rises a bit before intersecting the
minimum of the average total cost curve at 6.5 Stuffed Amigos.

What About Average Fixed Cost?

Although the average fixed cost curve is not displayed in this exhibit, average fixed
cost can be derived from the average total cost and the average variable cost curves.

First, note that the distance separating the average total cost curve and the average
variable cost curve is relatively wide for small quantities of output, but narrows with
greater production. The reason for the narrowing gap is that the difference between the
two curves is average fixed cost. Because average fixed cost declines with greater
production, so too does the gap between these curves.
As such, average fixed cost can be derived from this diagram by calculating the vertical
distance between the average total cost and the average variable cost curves. While an
average fixed cost curve is sometimes included in a diagram such as this one, it is not
really needed. So long the average total cost and the average variable cost curves are
available, average fixed cost can be obtained.

And What About the Totals?

All total cost values--total cost, total variable cost, and total fixed cost--can also be
derived from this diagram. If the output quantity, average total cost, and average
fixed cost, are known, then the total cost measures can be derived. Total cost is
quantity times average total cost. Total variable cost is quantity times average
variable cost. And total fixed cost is quantity times average fixed cost.

As such, this diagram of the three U-shaped cost curves provides all of the information
available about the cost incurred by a firm for short-run production.

"U-Shaped" Average Cost

The most useful "shape" for an investigation into the relationship between short-run
average cost and long-run average cost is the so-called "U-shape." Although this is a bit
misleading since we do not want the upward-pointing arms of the curve to ever be
perfectly vertical, it is this general shape for the average cost curve that corresponds to
an "S-shaped" total cost curve, as shown in the two charts below.
In the paired charts above, the upper chart shows a total cost curve, while the lower chart
shows the associated average cost and marginal cost curves. Note that the total cost curve
has an "S-shape," or "backwards-S" shape, while each of the average cost and
marginal cost curves has a "U" or "bowl" shape.

[ Question: Is the total cost curve a long-run total cost curve or a short-run total cost
curve; can we determine this visually?
Hint: According to the total cost curve, what is the total cost to produce zero units of
output? ]

Each of the charts has a diamond-shaped data marker located at an output of q = 30 and
each chart has a circular marker located at an output of q = 20. Interesting things occur at
these output levels!
In the chart showing the average and marginal cost curves only, reproduced below by
itself, each of the two data markers is located at a point that is "special" for an obvious
reason: the circular marker occurs at the minimum point on the marginal cost curve and
the diamond-shaped marker occurs at the minimum point on the average cost curve. In
addition, marginal cost is equal to average cost at the minimum point on the average cost
curve.

In the chart showing the total cost curve only, reproduced below by itself, note the
thin, solid line that begins at the lower-left corner of the chart and passes through the
diamond-shaped marker. Observe that the entire total cost curve lies above this thin, solid
line except at the diamond-shaped marker and where the total cost curve begins at q = 0.
Average cost at any level of output, AC = TC/q, has the geometric interpretation of being
the slope of a line drawn from the beginning point of the total cost curve at q = 0 to any
point on the total cost curve. Since the thin, solid line that passes through the diamond-
shaped marker at q = 30 is the "flattest" or "least steep" such line from the beginning
point at q = 0 to any point on the total cost curve, average cost reaches its minimum point
here, at q = 30!
Still analyzing the total cost curve, the circular data marker occurs where q = 20 and
there is a thin, dashed line that passes through the circular data marker. To understand
what is happening here, suppose that we were to draw a line that is tangent to the
total cost curve at q = 10. Would this line be "flatter" or "steeper" than the thin, dashed
line that passes through the circular data marker at q = 20?

Clearly, the line tangent to the total cost curve at q = 10 would be steeper than the thin,
dashed line that passes through the circular data marker at q = 20; see the chart below
with the thick, solid tangent line passing through the point on the total cost curve where
output is q = 10 and TC = $750.
Suppose we were to draw a line that is tangent to the total cost curve at q = 30. Would
this line be "flatter" or "steeper" than the thin, dashed line that passes through the circular
data marker at q = 20?

Actually, we do not even have to imagine this tangent line: the thin, solid line that passes
through the diamond-shaped marker at q = 30 is tangent to the total cost curve at q = 30;
see the original chart for total cost, which is reproduced below. Clearly, this tangent line
is steeper than the thin, dashed line that passes through the circular data marker at q = 20.

Indeed, every line that would be tangent to the total cost curve at an output less than
q = 20 would be steeper than the thin, dashed line passing through the circular marker at
q = 20. Further, every line that would be tangent to the total cost curve at an output
greater than q = 20 would be steeper than the thin, dashed line passing through the
circular marker at q = 20. Therefore, the thin, dashed line in the upper chart is the
"flattest" such tangent line. Since marginal cost at any level of output has the geometric
interpretation of being the slope of a line that is tangent to the total cost curve at that level
of output, the fact that the thin, dashed line through the circular marker at q = 20 is
tangent to the total cost curve at that point and it is the "flattest" such tangent line affirms
that marginal cost reaches its minimum point at q = 20!