Whichever market structure is involved, average factor cost is calculated as the total factor cost divided by the quantity of the factor purchased, as illustrated by this equation:

average factor cost

=

total factor cost factor quantity

total factor cost

=

average factor cost

x

factor quantity

Perfect competition is a market structure with a large number of small participants (buyers and sellers). The good exchanged in the market is identical, regardless of who sells or who buys. Participants have perfect knowledge and perfect mobility into and out of the market. These conditions mean perfectly competitive buyers are price takers, they have no market control and must pay the going market price for all inputs bought.

Average Factor Cost, Perfect Competition

The table to the right summarizes the average factor cost incurred by a hypothetical buyer, Maggie's Macrame Shoppe, for hiring store clerks in a perfectly competitive labor market. Maggie's Macrame Shoppe is one of thousands of small retail stores in the greater Shady Valley metropolitan area that hires labor with identical skills. As such, Maggie pays the going wage for labor.

The first column in the table is the quantity of workers hired, ranging from 0 to 10 workers. The second column is the price Maggie pays for hiring her workers, which is constant at $10 per worker. The third column is the total factor cost Maggie incurs for hiring various numbers of workers. If Maggie hires only one worker, then she pays only $10. If she hires five workers, she pays $50. In each case, total factor cost in column three is calculated as the quantity in the first column multiplied by the price in the second column.

The fourth column then presents the average factor cost incurred by Maggie at each level of employment. These numbers are found by dividing total factor cost in the third column by factor quantity in the first column. For example, the total factor cost of hiring five workers is $50, resulting in an average factor cost of $10 per worker.

The two key observations about average factor cost are:

• First, average factor cost is constant. Each level of employment results in the same $10 average factor cost.


• Second, average factor cost is equal to price at every level of employment. Average factor cost and price are basically two terms for the same concept.

Average Factor Cost Curve, Perfect Competition

The vertical axis measures average factor cost and the horizontal axis measures the quantity of input (workers). Although quantity on this particular graph stops at 10 workers, the nature of perfect competition indicates it could easily go higher.

First and foremost, the average factor cost curve is horizontal at the going factor price of $10. This indicates that if Maggie hires 1 worker, then she pays an average factor cost of $10. Alternatively, if she hires 10 workers, then she pays an average factor cost of $10. Should she hire 100 workers, then she might move well beyond the graph, but she pays an average factor cost of $10.