Q2Managerial Economics & Financial Accounting
Question
Explain the various types of cost with the help of suitable diagrams.
Answer
Cost concepts are categorized into fixed, variable, marginal, and average costs, each dictating short-run production decisions and forming specific U-shaped curves.
In the short run, costs are divided based on their relation to the quantity of output produced.
1. Total Fixed Cost (TFC): Costs that remain completely constant regardless of the output level (e.g., rent, insurance). The TFC curve is a horizontal line parallel to the output axis.
2. Total Variable Cost (TVC): Costs that vary directly with output (e.g., raw materials, direct labor). It starts at zero. The TVC curve is an inverse S-shape due to the law of variable proportions.
3. Total Cost (TC): The sum of TFC and TVC. The TC curve has the exact same shape as the TVC curve but starts from the TFC intercept on the Y-axis.
4. Average Fixed Cost (AFC): . Because TFC is constant, dividing it by a growing output means AFC continuously falls, forming a rectangular hyperbola curve that approaches but never touches the axes.
5. Average Variable Cost (AVC): . The AVC curve is U-shaped. It falls initially due to increasing efficiency, hits a minimum, and then rises due to diminishing returns.
6. Average Total Cost (AC): (or ). Also U-shaped, lying above the AVC curve. The gap between AC and AVC narrows as output increases because AFC is declining.
7. Marginal Cost (MC): The cost of producing one additional unit. It is derived entirely from variable costs. The MC curve is steeply U-shaped. Crucially, it cuts both the AVC and AC curves exactly at their minimum points from below.