2005 #51 (Output & Costs) Multiple Choice Question
So, was looking at questions with students and had a good time talking about this one.
Answer - (B) Spreading fixed costs over a larger output, and eventually diminishing returns.
Often, I explain the U-shaped curve as a reflection of Diminishing Marginal Returns and then stop but this question caused me to think about not only the rise in cost but the fall in costs.
If we look at a graph of the Average cost curves we see ATC with its U-Shape and we see AVC with its U-shape but AFC tends to decrease with more output.
This is because as output increases the average of the total fixed costs, per-unit decreases.
If your total fixed costs are $100 (rent) and you sell 1 unit, (wauffle), your total fixed costs are still $100 but
your Average fixed costs are $100 (OK be patient)
But if you sell a second waffle
then your Average Fixed costs are now $50
TFC/Q (output) = Average Fixed Costs, so $100/ 2(output) = $50
This decreasing AFC pulls down the ATC curve.
Lets use some numbers - ATC(5) = AVC (3) + AFC (2)
If average fixed costs decreases (as output increases) then ATC (4) = AVC (3) + AFC (1)
AFC decreases and therefore ATC has to decrease,, thus the falling of the curves.
ATC Curve is pulled down by the effect of AFC decreasing as output increases and pulled up as diminishing returns sets in.