In general, average variable cost decreases with additional production at relatively small quantities of output, then eventually increases with relatively large quantities of output. This pattern is illustrated by a U-shaped average variable cost curve.

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.

Calculating Average Variable Cost

average variable cost

=

total variable cost quantity of output

average variable cost = average total cost - average fixed cost

total variable cost = average variable cost x quantity of output

Stuffed Animal Cost

Average Variable Cost

Deriving average variable cost is as simple as dividing the second column of total variable cost values by the first column of output quantity values. The average variable cost of producing 1 Stuffed Amigo is relatively easy--divide $5 by 1 Stuffed Amigo. If the result of this calculation is not readily obvious, click the [One] button.

The average variable cost of two Stuffed Amigos might be a little less obvious, but not much. Click the [Two] button to reveal that the average variable cost is $4, which is $8 divided by 2 Stuffed Amigos. A click of the [Three] shows that the average variable cost of producing 3 Stuffed Amigos is $3.33, $10 divided by 3. The remaining average variable cost values can be displayed by clicking the [Remaining] button.

With all numbers displayed, what interesting insight into average variable cost can be had?

• First, average variable cost is relatively high for the first Stuffed Amigo produced, then declines. However, it reaches a low, then rises with production of the last few Stuffed Amigos. This is the U-shaped pattern noted above.


• Second, average variable cost remains positive, it never reaches a zero value and never turns negative. The only way for negative average variable cost is for negative total variable cost, which makes no theoretical or practical sense.

The Average Variable Cost Curve

Average Variable Cost Curve

The key feature of this average variable cost is the shape. It is U-shaped, meaning it has a negative slope for small quantities of output, reaches a minimum value, then has a positive slope for larger quantities. This U-shape is indirectly attributable to the law of diminishing marginal returns.