Question

Explain why the average fixed cost curve (AFC) slopes downward throughout, while the average variable cost curve (AVC) slopes down at first, but then turns upward.

Short answer

The average fixed cost (AFC) curve slopes downward throughout because fixed costs are spread over a greater number of produced units as production increases. The average variable cost (AVC) curve initially slopes downward due to increased efficiency and lower variable costs per unit; however, it turns upward as the law of diminishing marginal returns comes into effect, leading to decreased efficiency and increased variable costs per unit.

Step-by-step solution

Understand fixed and variable costs

Fixed costs are costs that do not change with the level of production, such as rent, salaries, and equipment costs. Variable costs are costs that change with the level of production, such as raw materials and labor expenses.

Define Average Fixed Cost (AFC)

Average Fixed Cost (AFC) refers to the fixed costs of production divided by the quantity produced. Mathematically, it can be expressed as: AFC = \( \frac{Fixed\, Costs}{Quantity\, Produced} \)

Define Average Variable Cost (AVC)

Average Variable Cost (AVC) refers to the variable costs of production divided by the quantity produced. Mathematically, it can be expressed as: AVC = \( \frac{Variable\, Costs}{Quantity\, Produced} \)

Explain the downward-sloping AFC curve

The average fixed cost (AFC) curve slopes downward throughout because as production increases, the fixed costs, which do not change, are spread over a greater number of units. Consequently, AFC decreases as the number of units produced increases.

Understand the law of diminishing marginal returns

The law of diminishing marginal returns states that as more of a variable input is added to production, the marginal product initially increases, but beyond a certain point, the marginal product of each additional input begins to decrease.

Describe the behavior of the AVC curve

The average variable cost (AVC) curve initially slopes downward because adding more inputs in production can lead to increased efficiency and lower variable costs per unit. However, as more inputs are added, the law of diminishing marginal returns comes into effect, leading to a decrease in efficiency and increased variable costs per unit. As a result, the AVC curve will eventually slope upward. Overall, the average fixed cost (AFC) curve slopes downward throughout due to spreading fixed costs over more units produced, while the average variable cost (AVC) curve initially slopes downward and then turns upward due to the law of diminishing marginal returns affecting variable costs.

Key concepts

Average Fixed Cost

Average Fixed Cost (AFC) is an important concept in understanding production economics. It refers to the total fixed costs divided by the number of units produced. Fixed costs are those that do not vary with the production volume, such as rent or salaries.
The AFC curve consistently slopes downward. This is because, as production increases, the same amount of fixed costs is distributed over more units, thereby reducing the cost per unit. Consider this: if a factory spends $1000 on rent (a fixed cost) and produces 100 units, the AFC is $10 per unit. If production increases to 200 units, the AFC becomes $5 per unit.

• Fixed costs remain constant regardless of the production level.
• As output increases, AFC decreases, reflecting the spreading of the fixed costs.
• AFC never increases with output, as the fixed cost 'per unit' continues to decline.

This makes the AFC curve a downward sloping line on a graph, reflecting that each unit produced shares a smaller piece of the fixed cost "pie" as production scales up.

Average Variable Cost

Average Variable Cost (AVC) addresses variable costs, which fluctuate with production levels. AVC is calculated by dividing the total variable costs by the number of units produced.
Initially, when production starts, the AVC curve slopes downward. Why? Because adding more workers or using more materials often leads to efficiencies. Imagine a factory that gets better output because workers specialize or resources are better utilized as the operation scales.
However, the story takes a turn. After a certain point, the law of diminishing marginal returns kicks in. This economics principle says that each additional unit of input, say labor, will at some point produce less additional output than before.

• Early efficiency gains lower the AVC as production increases.
• Diminishing returns mean additional costs grow more rapidly than output.
• The combined effect eventually causes the AVC curve to rise.

Therefore, unlike the AFC, the AVC curve will rise after initial reductions, as variable costs per unit start increasing with production.

Law of Diminishing Marginal Returns

The law of diminishing marginal returns is a key principle in economics that significantly affects cost behavior in production. It states that consistently adding more of one input (like labor) to fixed inputs (like a factory) will eventually result in smaller increases in output.
In practical terms, think about a crowded restaurant kitchen; adding more chefs doesn't necessarily mean more dishes cooked per hour, especially if they start "bumping elbows." Initially, productivity might improve, but eventually, too many inputs overcrowd the process and lead to inefficiencies.

• This principle affects production costs by increasing variable costs per unit at higher outputs.
• It explains why the AVC might start low but increase as more units are produced.
• The effect is a key reason why businesses must find the optimal level of variable input.

The law of diminishing marginal returns lays the foundation for understanding why costs behave non-linearly beyond certain production levels, which is critical for businesses to optimize their production strategies.