The average fixed cost can be defined as the total fixed cost divided by total units output. It is vital to know the difference between short and long runs to understand the fixed cost.
In the short run, fixed factors such as technology remain the same, i.e., inputs do not change.
In the long run, technology can change, meaning inputs can change.
Connected to long and short-run are topics of fixed inputs and variable inputs.
Fixed inputs: They are inputs whose quantity remains the same. When measured over a certain period.
Variable inputs: They are inputs whose amount varies over a certain period.
Therefore, an excellent way to define fixed cost is the total cost of all fixed inputs.
The traditional theory of costs analysed short-run and long-run. It concludes that the short-run and long-run cost curves are ‘U’ shaped.
According to the traditional theory on short-run costs, there must always be at least one fixed input in the firm while production occurs. Therefore, it divides short-run costs into fixed costs and variable costs. This gives us the formula, TC = TFC + TVC. Where TC is the total cost.
Total Fixed Costs
A fixed cost is a cost that remains regardless of the level of production. Fixed costs are incurred on capital machinery. As these assets are required to start production, fixed costs are constant over the short run regardless of production. It includes costs like expenses on land, depreciation of machinery, and salaries for administrative staff.
The concept of fixed costs is beneficial to a firm as:
They help in developing a pricing strategy,
They are used in calculating break-even analysis, and
They help in general decision-making.
It is denoted graphically by a straight line parallel to the x-axis as its value is constant.
Total Variable Costs
The variable costs are costs that are unstable over time. It changes in the long and the short run. They are incurred during the process of production and not before it. Therefore we can define variable costs as: Variables costs are the costs that are incurred on variable inputs required for the production of goods.
Therefore, TVC = f(Q), where Q is output.
They include costs like – raw materials and direct labour costs. Knowing their variable costs are helpful for the firm as they help in profit planning, pricing strategy, and cost control.
Graphically it is denoted by an inverse ‘S’ shape.
Short-run total costs or STC are the sums of total variable and fixed costs. As the total fixed costs are constant, the total costs are graphically the same shape as the variable costs but higher.
We can now learn about the average cost curves through our understanding of the total cost curves. The average cost curves are also derived from the total cost curves.
Average Fixed Cost
The average fixed cost is found by dividing the total fixed cost by the number of units of output.
It can be denoted as:
AFC = TFC/ Q
Average fixed cost gives us the fixed cost of producing a single unit. The total fixed cost is constant regardless of output. On the other hand, the average fixed cost declines with increased production. The TFC remains constant, and Q keeps rising. Therefore, the value of TFC/Q also keeps decreasing.
Due to the decline of average fixed cost, the graph of AFC is a rectangular hyperbola with a downward slope. In contrast, the TFC on the graph is a straight line.
Average Variable Cost
The average variable cost results from dividing the total variable cost by the units of output. The average variable cost formula is denoted as:
AVC = TVC / Q
The graph of the average variable cost is downward sloping at first, as the productivity of variable factors like labour increases. After reaching a minimum point, it then starts rising again. It starts to rise and keeps growing above the initial level. This occurs due to the law of diminishing returns. The firm has to keep increasing expenditure to get the same output levels.
Average Total Cost
The short-run total average cost (SAC) of a firm can be obtained simply by dividing the total cost by output units. It is denoted as
SAC = STC/Q.
STC = TVC + TFC
Dividing terms by Q,
STC/Q = TVC/Q + TFC/Q
= SAC = AVC + AFC
Therefore, SAC can also be found by adding the average fixed and variable costs.
Knowing the average total cost for a company is essential, even more so than understanding the total cost. The units produced in a given period will not cost the firm the same amount. However, they have to be sold at the same price. The per-unit production cost is therefore significant to the firm.
The total fixed cost is the expenditure on all fixed inputs in a given period. On the other hand, the total variable cost is all the expenditure on variable inputs. The sum of the total fixed cost and total variable cost is the total cost of production over a given period.
From these concepts, we can grasp an understanding of average costs. The average fixed cost is the fixed cost of producing a single unit. It can be arrived at by dividing the total fixed cost by the number of units produced. The average variable cost is the variable cost of producing a single unit. It can be found by dividing total variable cost by the number of units produced.