Influence of fixed and variable costs on average total costs: Total cost is the aggregate of fixed costs and variable costs. The average total cost is the aggregate obtained by dividing the total costs with the total number of units produced. It is also obtained by adding average fixed costs and average variable costs.
The average fixed cost will be less when the level of production increases. The average variable costs will be less due to the influence economies of large scale production. When production reach a particular stage, the average variable costs increases. But it may not increase suddenly. The total average Cost does not increase when the increase in average fixed cost is less than the increase in average variable cost.
This is explained in the following table:
As shown in the above table, the average fixed cost and the average variable cost are less when the number of units produced is two. When the firm produces 3 Units, the average variable cost increases from Rs. 8 to Rs. 12. But the increase in average variable cost is greater than the decrease in average fixed cost. This leads to a fall in the average total cost. The average total cost increases at the 4th unit as average variable cost is more than the average fixed cost. The average total cost is at its minimum at the production of 3rd unit. This quantity of output produced by a firm is known as optimum quantity output.
Diagrammatic Representation of Different costs
In the diagram AFC is the Average Fixed Cost curve AVC is the Average Variable Cost curve. ATC is the Average total cost curve. MC is the Marginal Cost curve. MC curve cuts the AC curve at its minimum point P from below.
‘P’ is the minimum point on the AC curve. Production at this point secures normal profits. Hence OM is the optimum output.
Importance of different costs
The importance of the different costs is explained as below
1) The price of a commodity must always be equal to the Average Total Cost. Otherwise output can’t be produced in the long period. The Average Total Cost includes the minimum profits. A firm is said to earn normal profits if its price is equal to the Average cost.
2) The firm incurs losses when the price is less than its average variable cost. It can continue its production activities when the price is equal to the average variable cost. If the firm wants to stop its production, it incurs huge losses. So it has to continue production for sometime in the short-run to minimize the loss and to earn revenue equal to the variable costs.
The difference between fixed costs and variable cost is a short term phenomenon. We don’t observe this distinction in the long period. In the long period all costs are variable in nature. A firm increases its level of output for meeting the changes in demand, by varying all factors of production. So the analysis of costs into fixed and variable costs is a Temporary phenomenon. Hence, it is not applicable in the long period.