Average Variable Cost

Definition

Average variable cost is the total variable costs divided by the quantity of output produced. It represents the average cost of each additional unit of production, excluding fixed costs, and is an important consideration for firms in the long run and when making output decisions in perfect competition.

5 Must Know Facts For Your Next Test

1. Average variable cost decreases as output increases due to economies of scale, up to the point of minimum efficient scale.
2. Firms in perfect competition will produce up to the point where price equals marginal cost, which is also the point where price equals average variable cost.
3. In the long run, firms will exit the market if price is below their average variable cost, as they cannot cover their variable expenses.
4. Average variable cost is a crucial factor in a firm's supply decision, as it determines the minimum price at which the firm is willing to produce.
5. Minimizing average variable cost is a key objective for firms, as it allows them to maximize profits and remain competitive in the long run.

Review Questions

• Explain how average variable cost is related to a firm's output decisions in the long run.
  • In the long run, a firm's output decision is heavily influenced by its average variable cost. Firms will aim to produce at the level of output where price equals marginal cost, which is also the point where price equals average variable cost. This is because at this level of output, the firm can just cover its variable expenses and continue operating. If price falls below average variable cost, the firm will incur losses and will be incentivized to exit the market in the long run, as it cannot sustain its operations.
• Describe how changes in average variable cost affect a firm's supply decisions in a perfectly competitive market.
  • In a perfectly competitive market, a firm's supply decision is directly linked to its average variable cost. As average variable cost decreases, the firm's supply curve shifts to the right, indicating that the firm is willing to supply more output at any given price. Conversely, if average variable cost increases, the firm's supply curve shifts to the left, as the firm is only willing to supply less output at any given price. This is because average variable cost represents the minimum price at which the firm is willing to produce, and firms in perfect competition will produce up to the point where price equals marginal cost, which is also the point where price equals average variable cost.
• Analyze the relationship between a firm's average variable cost and its long-run cost structure in the context of perfect competition.
  • In a perfectly competitive market, a firm's long-run cost structure is heavily influenced by its average variable cost. Firms that are able to minimize their average variable costs will have a competitive advantage in the long run, as they can offer lower prices while still covering their variable expenses. This allows them to remain in the market and potentially earn economic profits. Conversely, firms with higher average variable costs may struggle to remain competitive in the long run, as they will be forced to exit the market if price falls below their average variable cost. Therefore, the ability to maintain low average variable costs is a crucial factor in a firm's long-run survival and success in a perfectly competitive industry.

Related terms

Variable Costs: Variable costs are expenses that change in proportion to the level of production, such as raw materials, labor, and utilities.

Fixed Costs: Fixed costs are expenses that do not change with the level of output, such as rent, insurance, and administrative overhead.

Marginal Cost: Marginal cost is the additional cost of producing one more unit of output, and is closely related to average variable cost.