What this lesson teaches
I can define total, average, fixed and variable costs.
Syllabus K343, 3.6.1. Definitions of costs of production: total cost (TC), average total cost (ATC), fixed cost (FC), average fixed cost (AFC), variable cost (VC), average variable cost (AVC)
I can calculate costs of production and draw how they change with output.
Syllabus K343, 3.6.2. Calculation of costs of production: calculation of TC, ATC, FC, AFC, VC and AVC; drawing and interpretation of diagrams that show how changes in output affect costs of production
Make a guess
A firm with fixed costs of $1,000 doubles its output from 100 to 200 units. What happens to its average fixed cost?
- It doubles, because the firm makes more.
- It stays at $10, because fixed cost is fixed.
- It halves, from $10 to $5 per unit.
Show the answer
It halves, from $10 to $5 per unit.
The same $1,000 is spread over twice as many units. This is why AFC always falls as output rises.
Average costs divide each total by output: ATC = TC / Q, AFC = FC / Q, AVC = VC / Q.
Average cost is the cost of each unit. Average total cost (ATC) = TC / output. Average fixed cost (AFC) = FC / output. Average variable cost (AVC) = VC / output. Also, ATC = AFC + AVC.
As output rises, AFC always falls. The same fixed cost is shared across more units. This is called spreading the fixed cost.
AVC usually falls at first, as workers specialise and machines are used fully, then rises as the firm gets crowded and less efficient. So ATC is U-shaped.
Firms watch ATC closely. If the price they can charge is above ATC, each unit makes a profit.
- ATC
- TC / output = AFC + AVC.
- AFC
- FC / output; always falls as output rises.
- AVC
- VC / output; usually falls then rises.
| Output | FC | VC | TC |
|---|---|---|---|
| 1 | 100 | 40 | 140 |
| 2 | 100 | 70 | 170 |
| 3 | 100 | 90 | 190 |
| 4 | 100 | 120 | 220 |
| 5 | 100 | 170 | 270 |
| Output | ATC | AFC | AVC |
|---|---|---|---|
| 1 | 140 | 100 | 40 |
| 2 | 85 | 50 | 35 |
| 3 | 63.33 | 33.33 | 30 |
| 4 | 55 | 25 | 30 |
| 5 | 54 | 20 | 34 |
Worked example: Working through a cost table
A small workshop has fixed costs of $100 a day. Use the table below.
- At 2 units: TC = 100 + 70 = $170, so ATC = 170 / 2 = $85.
- At 4 units: TC = 100 + 120 = $220, so ATC = 220 / 4 = $55.
- AFC falls from $50 at 2 units to $25 at 4 units, as fixed cost is spread.
- AVC at 4 units = 120 / 4 = $30.
Watch out for this
Average total cost is total cost divided by the price.
ATC is total cost divided by output, the number of units made. Price is a revenue measure, not a cost.
Check your understanding
A firm has fixed costs of $600 and variable costs of $900 when it makes 300 units. What is its ATC?
- $1,500
- $3
- $5
Show the answer
$5
Right. TC = 600 + 900 = 1,500, and 1,500 / 300 = $5.
Check your understanding
At 500 units a month, a workshop pays $3,000 rent and $2,000 for materials and power. What are its AFC and AVC?
- AFC $3,000 and AVC $2,000
- AFC $4 and AVC $6
- AFC $6 and AVC $4
- AFC $10 and AVC $10
Show the answer
AFC $6 and AVC $4
Right. Rent is fixed: $3,000 / 500 = $6. Materials and power vary: $2,000 / 500 = $4.
Check your understanding
As output rises, the gap between ATC and AVC narrows. Why?
- AVC keeps rising until it finally meets ATC
- AFC, which is the gap, falls as output rises
- Variable costs per unit fall as the firm grows
- MC pulls the two curves closer together over time
Show the answer
AFC, which is the gap, falls as output rises
Right. ATC = AVC + AFC, so the gap is AFC. A fixed sum spread over more units shrinks.