(a) Average Cost (AC)
It is per unit cost of production of a commodity. According to Ferguson, "Average cost is total cost divided by output". AC is calculated by dividing the total cost by the number of units produced. Suppose the total cost of production of 25 chairs is र 2,500. In this case, cost per chair or
AC can also be measured by adding AFC and AVC, i.e.,
AC = AFC + AVC
(Remember AC is formally called ATC)
Why is AC curve U-shaped? It means that initially it falls, after reaching its minimum, it starts rising. AC curve is depicted in Fig. AC curve in short period is a U-shaped curve due to operation of law of variable proportion. Remember, increasing returns imply diminishing costs, constant returns mean constant costs and diminishing returns imply increasing costs. As output is increased, initially AC falls due to operation of law of increasing returns, reaches its minimum and then rises due to diminishing returns. Hence, AC curve becomes U-shaped. Minimum point of AC curve indicates lowest per unit cost or production.
Why is LAC Curve U-shaped?
Simply put, the U-shape of the LAC curve is the result of operation of returns to scale, i.e., a firm experiences increasing returns to scale (i.e. diminishing cost) in the beginning followed by constant returns to scale and then by diminishing returns to scale (i.e. increasing cost) (see Q. 3.7). It is explained below. Remember that increasing returns means decreasing costs and diminishing returns imply increasing costs. That is why law of diminishing returns is called as law of increasing costs and law of diminishing returns is called as law of increasing costs.
(i) It is because of increasing returns to scale (i.e., decreasing costs) that LAC curve declines initially when a firm expands production from small scale to large scale. (ii) When AC becomes lowest as a result of increasing returns, a firm experiences constant returns for a while. (iii) A further increase in the scale of output beyond a certain point results in diseconomies of scale. This leads to decreasing returns (i.e., increasing costs). It is because of decreasing returns to scale that LAC curve starts rising.
In short, LAC curve first declines due to economies of scale and then rises due to diseconomies of scale. This briefly explains the U-shape of LAC curve. U-shape of LAC curve, in turn, implies U-shape of LMC curve.
Area under MC curve = TVC.
We have seen that MC is addition to the total variable cost when an additional unit is produced. This means that total variable cost (TVC) is the sum of marginal costs because total fixed costs remain the same in short period. This is proved in Fig. 3.9. Assuming output perfectly divisible, a hypothetical smooth MC curve is drawn in the adjoining figure. We know that TVC is simply the sum of marginal costs of number of units produced. Thus under the assumption of smooth marginal cost curve, total variable cost (TVC) is equal to the area under marginal cost curve. For instance at OQ units of output, TVC is equal to the shaded area OABQ in the diagram.
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