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Concept
Average cost
Summary
In economics, average cost or unit cost is equal to total cost (TC) divided by the number of units of a good produced (the output Q):
Average cost has strong implication to how firms will choose to price their commodities. Firms’ sale of commodities of certain kind is strictly related to the size of the certain market and how the rivals would choose to act.
Short-run costs are those that vary with almost no time lagging. Labor cost and the cost of raw materials are short-run costs, but physical capital is not.
An average cost curve can be plotted with cost on the vertical axis and quantity on the horizontal axis. Marginal costs are often also shown on these graphs, with marginal cost representing the cost of the last unit produced at each point; marginal costs in the short run are the slope of the variable cost curve (and hence the first derivative of variable cost).
A typical average cost curve has 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 intersects a U-shaped average cost curve at the latter's minimum, after which 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. For example: for a factory designed to produce a specific quantity of widgets per period—below a certain production level, average cost is higher due to under-used equipment, and above that level, production bottlenecks increase 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.
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