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 RESERVATION PRICE: The lowest price at which a supplier is willing to supply any amount of a good. This is usually based on the minimum cost of production. For labor, it's the lowest wage that makes it worthwhile to get up in the morning, miss your favorite daytime television shows, and go to work.

AVERAGE COST:

The opportunity cost incurred per unit of good produced. This is calculated by dividing the cost of production by the quantity of output produced. While average cost is a general term relating cost and the quantity of output, three specific average cost terms are average total cost, average variable cost, and average fixed cost. A related cost term is marginal cost.
Average cost is a general notion of the per unit cost incurred in the production of a good or service. It is specified as the total cost divided by the quantity of output. Average cost plays a key role in the short-run production decision by a firm when evaluated against the price, which is per unit revenue. A comparison between per unit revenue (price) and per unit cost (average cost) indicates whether a firm is making a profit, incurring a loss, or should shut down production operations.

A Couple of Equations

A generic formula for calculating average cost is specified as:

 average cost = total costquantity of output

This equation can be turned on its head to calculate total cost from average cost:

 total cost = average cost x quantity of output

Three Averages

Short-run production analysis makes use of three average cost measures--average total cost, average fixed cost, and average variable cost. Each is derived from a corresponding total--total cost, total fixed cost, and total variable cost.
• Average Total Cost: This is per unit total cost, or total cost divided by the quantity of output produced. Average total cost is also the sum of average fixed cost and average variable cost.

• Average Fixed Cost: This is per unit total fixed cost, or total fixed cost divided by the quantity of output produced. Because fixed cost does not vary with output, average fixed cost declines with larger quantities of production.

• Average Variable Cost: This is per unit total variable cost, or total variable cost divided by the quantity of output produced. Average variable cost is influenced by short-run marginal returns, decreasing for small quantities, then increasing for larger quantities.

Short-run Production Analysis

Average cost is perhaps most important for short-run production analysis, especially when serious talk turns to the topic of profit. In terms of totals, profit is the difference between total revenue and total cost. However, profitability can also be identified per unit of output. In this case, a comparison between price (the revenue received for each unit sold) and average cost is highly informative. If price exceeds average total cost, then profit is received for each unit sold. If price is less than average total cost, then each unit is sold at a loss.

This price-average cost comparison is just the sort of thing that can keep a firm from bankruptcy. In fact, those firms that have some degree of control over price, frequently set prices based on average cost. The most common techniques used are mark-up pricing or cost-plus pricing, which ensure that firms cover cost and receive a profit on each unit sold.

Suppose, for example, that the average cost incurred by Waldo's TexMex Taco World in the production of Super Deluxe TexMex Gargantuan Tacos is \$3. If each Super Deluxe TexMex Gargantuan Taco sells for \$3.50, then Waldo's TexMex Taco World receives \$0.50 per taco. In all likelihood, Waldo's TexMex Taco World sets the price at \$3.50 for their Super Deluxe TexMex Gargantuan Tacos by adding a "reasonable" fifty-cent per taco profit to the three dollar per taco cost.

Profit, Loss, or Shutdown

Per unit profitability is not the only information that can be garnered with a comparison of price and average cost. In fact, firms face three short-run alternatives revealed by price and average cost.
• Produce at a Profit: The first alternative, the one sought after by profit-maximizing firms, is to generate a positive profit on output produced. This is achieved if price is equal to or greater than average total cost.

• Produce at a Loss: A second alternative is to produce output in the short run, even though profit is negative, that is, the firm incurs a loss. This is achieved if the price is greater than average variable cost, but less than average total cost. The loss from production is less than the fixed cost loss that would be incurred by shutting down production.

• Shutdown Production: The last alternative is to stop producing in the short run and incur the loss of fixed cost. This is achieved if price is less than average variable cost. The loss from production is greater than the fixed cost loss incurred by shutting down production.

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Recommended Citation:

AVERAGE COST, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: September 20, 2024].

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