Which of the following is true of average cost? Group of answer choices
a. It is always larger than marginal cost.
b. It declines for some range of output, hits a minimum, then increases.
c. It is always smaller than marginal cost.
d. It is the total cost/price of the product.
The correct answer and explanation is:
Correct Answer: b. It declines for some range of output, hits a minimum, then increases.
Explanation (300 words):
Average cost (AC), also known as average total cost (ATC), is a key concept in microeconomics used to analyze the cost of production. It is defined as: Average Cost (AC)=Total Cost (TC)Quantity of Output (Q)\text{Average Cost (AC)} = \frac{\text{Total Cost (TC)}}{\text{Quantity of Output (Q)}}
Average cost includes both fixed costs (which do not change with output) and variable costs (which change with output). As a firm begins to produce more units, the average cost behaves in a characteristic U-shape, particularly in the short run.
Initially, average cost declines as output increases. This is due to economies of scale and the spreading of fixed costs over a larger number of units. For example, if a factory’s fixed costs are $1,000 and it produces 10 units, the fixed cost per unit is $100. But if it produces 100 units, the fixed cost per unit drops to $10.
However, after a certain point, producing additional units leads to increasing marginal costs, due to diminishing returns to variable inputs (like labor or materials). When marginal cost (MC) starts rising and eventually becomes higher than average cost, it pulls the average cost upward, causing the AC curve to rise.
So, the average cost curve typically:
- Decreases at first (due to increasing efficiency),
- Reaches a minimum point,
- Then increases (due to inefficiencies or capacity limits).
This behavior is what makes option (b) the correct answer.
The other options are incorrect because:
- (a) and (c) wrongly assume a fixed relationship between AC and MC.
- (d) confuses average cost with total cost or price, which are separate concepts.
Understanding the behavior of average cost is crucial for firms to determine optimal production levels and pricing strategies.