Adam Kizer
Rabina Sherchan

Average Variable Cost (AVC) is defined as total variable cost divided by the number of units of output. Average variable cost helps to provide a measure of variable costs on a per unit basis. The formula can be represented as Total Variable Cost divided by the output. AVC=TVC/output. AVC is one of the components of Average Total Cost (ATC), the other component being Average Fixed Cost (AFC). This can be represented by the formula AVC = ATC- AFC

Average variable cost, when combined with price, indicates whether or not a firm should shut down production in the short run. If price is greater than average variable cost, then the firm is able to pay all variable cost and a portion of fixed cost. Even though it might be incurring an economic loss, it will lose less by producing that by shutting down production. If, however, price is less than average variable cost, then the firm is better off shutting down production.

Average Variable Cost Curve
Cost33b.gif

The U-shape of the AVC curve:
The U-shape of the average variable cost curve is indirectly caused by increasing, then decreasing marginal returns (and the law of diminishing marginal returns). The negatively-sloped portion is attributable to increasing marginal returns and the positively-sloped portion is attributable to decreasing marginal returns (and the law of diminishing marginal returns). In the short run, as we continue to produce higher levels of output, AVC initially declines, then reaches a minimum and finally begins to increase. Initial decline maybe a result of specialization that comes with increased output and the eventual decline may occur due to fixed factors. Average variable cost always remains positive, it never reaches a zero value and never turns negative.

AVC, ATC and MC:
In the short run, with higher level of outputs, ATC and AVC gets closer to each other because the AFC is spread over many units of output. Also the marginal cost curve will intersect the AVC curve at its minimum point.

MCATC.jpg
Examples

Here is an example of Average Variable Cost. The chart belows displays the quantity, variable cost, and the average variable cost for producing stuffed animals. The average variable cost was found by dividing the variable cost of producing the stuffed animal(s) by the quanity. This chart help to illustrate the graph above because the AVC starts at $5.00 then decreases to a low of $2.50 before it starts increasing again.

AVC for Stuffed Animals
external image AVC001wd.gif


Questions

1) If a company is producing 20 units with a variable cost of of $100. What is the Average Variable Cost?
a) $0.20
b) $5
c) $2000
d) $40

The answer is B. Average Variable cost is found by dividing Variable Cost by the Quanity (100/20).

2) What is the Average Variable Cost when Total Cost is $1500 and Total Fixed Cost is 500 for 5 units of output produced?
a) $1000
b) $200
c) $2000
d) $400

The answer is B. AVC= ATC-AFC and ATC and AFC are obtained by dividing TC and TFC by units of output respectively.

3) In the short run, with higher level of outputs, what happens to ATC and AVC?
a) Remains unchanged
b) Furthers from each other
c) Gets closer to each other
d) None of the above

The answer is C. This is because the AFC is spread over many units of output.

4) What is the Average Variable Cost when AFC is $20 and ATC is $40?
a) $60
b) $20
c) -$20
d) None of the above

The answer is B because AVC is found by subtracting AFC from ATC ($40-$20).

5) Where does the Marginal Cost curve intersect the Average Variable Cost curve?
a) At its lowest point
b) At its highest point
c) It doesn't intersect, but runs parallel to it
d) None of the above

The answer is A, the marginal cost curve intersects the AVC curve at its lowest point.

6) True or False: Average variable cost always remains positive, it never reaches a zero value and never turns negative.

The anser is True. The only way for negative average variable cost is for negative total variable cost, which makes no theoretical or practical sense.

References

1. Managerial Economics and Business Strategy, Michaeal R. Baye, Fourth Edition, Chapter 5
2. http://en.wikipedia.org/wiki/Average_variable_cost
3. http://64.233.167.104/search?q=cache:Nod_6KbtQ8sJ:www.ssu.missouri.edu/faculty/bbullock/agecon41/notes/apr16notes.pdf+average+variable+costs&hl=en&ct=clnk&cd=1&gl=us
4. http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=average+variable+cost
5. http://learning.mazoo.net/archives/000873.html
6. http://www.econ.ucsb.edu/~tedb/Courses/Ec1W2007/Lec07/Exp8Lec8.swf