Important Relationship between Various Types of Costs | Micro Economics (2024)

There exists a close relationship between the various types of costs. Let us understand the relationship between the following costs:

1. Average Cost (AC) and Marginal Cost (MC)

2. Average Variable Cost (AVC) and Marginal Cost (MC)

3. Average Cost (AC) and Average Variable Cost (AVC) and Marginal Cost (MC)

4. Average Cost (AC) and Average Variable Cost (AVC)

5. Total Cost (TC) and Marginal Cost (MC)

6. Total Variable Cost (TVC) and Marginal Cost (MC)

Relationship between AC and MC:

There exists a close relationship between AC and MC.

i. Both AC and MC are derived from total cost (TC). AC refers to TC per unit of output and MC refers to addition to TC when one more unit of output is produced.

ii. Both AC and MC curves are U-shaped due to the Law of Variable Proportions. The relationship between the two can be better illustrated through following schedule and diagram.

Table 6.8: Relationship between AC and MC:

With the help of Table 6.8 and Fig. 6.9, the relationship can be summarized as under:

1. When MC is less than AC, AC falls with increase in the output, i.e. till 3 units of output.

2. When MC is equal to AC, i.e. when MC and AC curves intersect each other at point A, AC is constant and at its minimum point.

3. When MC is more than AC, AC rises with increase in output, i.e. from 5 units of output.

4. Thereafter, both AC and MC rise, but MC increases at a faster rate as compared to AC. As a result, MC curve is steeper as compared to AC curve.

AC depends on the nature of MC:

i. When MC curve lies below the AC curve, it pulls the latter downwards;

ii. When MC curve lies above AC curve, it pulls the latter upwards;

iii. Consequently, MC and AC are equal where MC intersects AC curve.

Can AC fall, when MC is rising?

Yes, AC can fall, when MC is rising. However, it is possible only when MC is less than AC. It means that as long as MC curve is below the AC curve, AC will fall even if MC is rising. As per Table 6.8, when we move from 2 units to 3 units, MC rises and AC falls. It happens because during this range, MC is less than AC.

Can AC rise, when MC is falling?

No, AC cannot rise, when MC is falling because when MC falls, AC will also fall.

Conceptual Clarity — Relationship between AC and MC:

The relationship between AC and MC can be better understood through example of a ‘Cricketer’s Batting Average’ given by Stonier and Hague in their book ‘A Text Book of Economic Theory’.

Assume that a cricketer (say, Sachin Tendulkar) has scored 180 runs in 3 matches. It means, his present average score is: 180 / 3 = 60 runs. Now, consider the following 3 cases:

Case 1:

Sachin scores 50 runs in his 4th match. Now, his average score will fall as his marginal score is less than the average score. This is shown in the following table:

When the marginal score is less than the average score, average score will decrease. Similarly, when MC < AC, AC will fall.

Case 2:

If Sachin scores 60 runs in the 4th match, then his average and marginal score will be equal as his marginal score is equal to average score.

When the marginal score is equal to average score, average score will remain constant. Similarly, when MC = AC, AC is constant.

Case 3:

If Sachin scores 80 runs in the 4th match, then his average will rise as his marginal score is more than the average score.

When the marginal score is more than the average score, average score will increase. Similarly, when MC > AC, AC will rise.

Relationship between AVC and MC:

The relationship between AVC and MC curves is similar to that of AC and MC.

i. Both AVC and MC are derived from total variable cost (TVC). AVC refers to TVC per unit of output and MC is the addition to TVC, when one more unit of output is produced.

ii. Both AVC and MC curves are U-shaped due to the Law of Variable Proportions.

The relationship between AVC and MC can be better illustrated with the help of following schedule and diagram.

Table 6.9: Relationship between AVC and MC

1. When MC is less than AVC, AVC falls with increase in the output, i.e. till 2 units of output.

2 When MC is equal to AVC, i.e. when MC and AVC curves intersect each other at point B), AVC is constant and at its minimum point (at 3rd unit of output).

3. When MG is more than AVC, AVC rises with increase in output, i.e. from 4 units of output.

4. Thereafter, both AVC and MC rise, but MC increases at a faster rate as compared to AVC. As a result, MC curve is steeper as compared to AVC curve.

Relationship between AC, AVC and MC:

The relationship between AC, AVC and MC can be better illustrated with the help of following schedule and diagram.

Table 6.10: Relationship between AC, AVC and MC:

1. When MC is less than AC and AVC, both of them fall with increase in the output.

2. When MC becomes equal to AC and AVC, they become constant. MC curve cuts AC curve (at ‘A’) and AVC curve (at ‘B’) at their minimum points.

3. When MC is more than AC and AVC, both rises with increase in output.

Relationship between AC and AVC:

The relationship between AC and AVC can be discussed with the help of Fig. 6.11.

1. AC is greater than AVC by the amount of AFC.

2. The vertical distance between AC and AVC curves continues to fall with increase in output because the gap between them is AFC, which continues to decline with rise in output.

3. AC and AVC curves never intersect each other as AFC can never be zero.

4. Both AC and AVC curves are U-shaped due to the Law of Variable Proportions.

5. MC curve cuts AVC and AC curves at their minimum points.

6. The minimum point of AC curve (point A) lie always to the right of the minimum point of AVC curve (point B).

Important Observations: AC, AVC and MC (Refer Fig. 6.11):

1. MC = AVC at first unit of output (Point C):

MC is addition to TVC by producing one more unit of output. As TVC of one unit of output is same as AVC, both MC and AVC are equal at the first unit of output.

2. AC, AVC and MC are U-shaped curves:

All these curves are U-shaped due to Law of Variable proportions.

3. Minimum point of MC curve comes before the minimum points of AC and AVC curves:

MC curve reaches its minimum point (point ‘D’) before the AC curve (point ‘A’) and AVC curve (point ‘B’) reaches their minimum points.

4. MC curve is common to both AVC and AC curve:

MC reflects change in either total cost or total variable cost. So, MC curve is common to both AVC and AC curve.

5. MC curve cuts AC and AVC curves at their minimum points:

When MC is less than AC and AVC, MC pulls both of them downwards. Similarly, when MC is more than AC and AVC, MC pulls both of them upwards. As a result, MC curve cuts AC curve (at ‘A’) and AVC curve (at ‘B’) at their minimum points.

Relationship between TC and MC:

The main points of relationship between TC and MC are:

1. Marginal cost is the addition to total cost, when one more unit of output is produced. MC is calculated as: MC_n = TC_n – TC_n-1

2. When TC rises at a diminishing rate, MC declines.

3. When the rate of increase in TC stops diminishing, MC is at its minimum point, i.e. point E in Fig. 6.12.

4. When the rate of increase in total cost starts rising, the marginal cost is increasing.

Relationship between TVC and MC:

We know, MC is addition to TVC when one more unit of output is produced. So, TVC can be obtained as summation of MC’s of all the units produced. If output is assumed to be perfectly divisible, then total area under the MC curve will be equal to TVC.

As seen in the diagram, at OQ level of output, TVC is equal to the shaded area OPLQ in the diagram.