Average Variable Cost

Josh Reising

Average variable cost provides a measure of variable costs on a per-unit basis and is defined as variable cost (VC) divided by the number of units per output (Q):

AVC = VC / Q

Keep in mind that variable costs are costs that change when output is changed. Variable costs grow with higher levels of production (proportionally or not). If there are only variable costs, at zero production the total costs will be zero.

AVC_Table_1.png

Having only variable costs is rarely the case, as fixed costs are almost always present. Fixed costs are those that do not vary with output, so regardless of the quantity a firm will produce the fixed costs will remain constant. Graphically, we can see the relationship between fixed, variable, and total cost.

AVC_Graph_2.png

As you can see the difference between Total Cost and Variable Cost is the amount of Fixed Cost, or TC – VC = FC.

The next graph shows the relationship between average total, average variable, average fixed and marginal costs. First, notice that the marginal cost curve intersects the average total cost (ATC) and average variable cost (AVC) curves at their minimum points. Therefore, when marginal cost is below an average cost curve, average cost is declining, and when marginal cost is above average cost, average cost is rising.

AVC_Graph_3.png

For example, consider the number of bottles of wine a vintner can make over the course of many seasons. In one season, if the vines do not produce as many grapes as usual fewer bottles than average will be produced, and the average number of bottles made will drop. On the other hand, if the crop is more robust the following year more bottles of wine will be produced, thus increasing the average. Essentially, the number of bottles produced each year is the marginal contribution to the overall average. When the marginal contribution is above the average, the average increases; when the marginal contribution is below the average, the average decreases.

Also, you will notice that the ATC and AVC curves get closer together as output increases. This is because the only difference in ATC and AVC is AFC, as mentioned before. Since average fixed costs decline as output is expanded the difference between average total and average variable costs diminishes as fixed costs are spread over increasing levels of output.

Multiple Choice Questions:

1) When referencing the relationship between cost curves, the marginal cost curve will intersect the Average Variable Cost curve...
a) where the AVC curve is declining
b) where the AVC curve is inclining
c) at its minimum point
d) at its origin

2) The ATC and AVC curves in the graph below get closer as output increases because...
AVC_Graph_3.png
a) marginal costs increase as output contibue to rise
b) average fixed costs decline as output is expanded
c) ATC - AVC = AFC
d) both b & c

3) Which of the following is NOT an example of a variable cost?
a) personnel/workforce
b) building rent
c) cost of raw materials
d) energy

4) Under perfect competition, if a firm sets its price higher than the average cost curve in the short run, the firm should continue to do business.
True
False

5) The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the AVC curve.
True
False

Answers:
1) C - The Marginal Cost Curve will intersect the Average Variable Cost Curve at its minimum point, which implies that when the marginal cost is below the average cost, average cost is declining, and when the marginal cost is above average cost, average cost is rising.
2) D - Both b & c are true because average fixed costs tend to decrease as output increases, and AVC + AFC = ATC.
3) B - Building rent is an example of a fixed cost, while all the other examples listed are variable because the manager can adjust them to alter production.
4) True - To maximize short run profits, a perfectly competetive firm should produce in the range of increasing marginal cost when P = MC, provided that P > AVC. If P < AVC, the firm should shhut down its plant to minimize its losses.
5) True - when price falls below the AVC curve the firm produces zero units because it does not cover the variable costs of production.


References:
Baye, Michael R. 2006.
Managerial Economics and Business Strategy__. McGraw-Hill/Irwin: New York, NY.
Piana, Valentino. 2003. Economics Web Institute. Retrieved on 10/14/2007 from http://www.economicswebinstitute.org/glossary/costs.htm
Baker, Samuel L. 2007. Economics Interactive Tutorial. Retrieved on 10/14/2007 from http://hspm.sph.sc.edu/COURSES/ECON/Cost/Cost.html
Prof. Larry DeBrock, University of Illinois, Cost Lecture, 2006, retrieved 10/14/07 from
http://www.business.uiuc.edu/ldebrock/PTMBAe567/Lectures/Costs/costs.htm