0:12

In our last module,

Â we worked our way through the concepts of fixed costs,

Â variable costs, total costs,

Â and marginal cost, as a way of understanding short run cost analysis.

Â We need to continue that journey now by introducing the final three columns in our table,

Â for average fixed cost,

Â average variable cost, and average total cost.

Â Note that these three columns are simply derived by calculating

Â averages using columns one through four and the formulas in the table.

Â For example, the average fixed costs for an output of five is

Â simply fixed costs divided by five for a total of 10.

Â So to make sure you grasp this idea,

Â see if you can fill in the question marks in the table.

Â Just pause the presentation now and do so.

Â Did you get this exercise right?

Â Okay. Now, take a look at this figure,

Â which provides a graphical interpretation of

Â the very important relationships between marginal

Â cost and our three main average cost measures: average fixed costs,

Â AFC, average variable costs,

Â AVC, and average total costs, ATC.

Â Please study this figure carefully now for

Â a few minutes as you try to answer these questions.

Â Why does the AFC curve slope downward and approach zero on

Â the horizontal axis while the AVC curve approaches the ATC curve?

Â Why does the marginal cost or MC curve intersect both

Â the AVC and AC curves at their minimums?

Â Please pause the presentation now to contemplate these questions,

Â which actually have very important implications

Â for operations and supply chain management.

Â 2:29

Okay. Let's start with the easiest question.

Â Why does the AFC curve slope downward and approaches zero on the horizontal axis?

Â That is simply because as a firm's output increases,

Â it spreads its fixed costs over a larger number of

Â units so average fixed costs must fall.

Â This is an important insight because one of

Â the benefits of increased production volume is to the spread

Â fixed costs over more and more units and

Â figuring out ways to do that is an important part of the planning process.

Â I should also point out here that in complex organizations,

Â the accounting team often has a very difficult time properly

Â allocating the fixed costs of a firm over multiple activities of the firm.

Â Get that allocation wrong,

Â and you can sometimes provide a very skewed picture of what

Â portions of the firm's activities are profitable and which may not be.

Â 3:34

Next question, why does

Â the average variable cost curve approach the average total cost curve?

Â Of course, because as average fixed costs fall this must be the case.

Â As for the hardest question,

Â why is the marginal cost curve MC intersect

Â both the AVC and AC curves at their minimums?

Â First, let's refresh your memories as to why the ATC,

Â AVC and MC curves slope first down and then up.

Â It's the law of diminishing returns, right?

Â As for why the MC curve intersects both the AVC and AC curves at their minimums,

Â the answer lies in these key formulas.

Â If marginal cost is greater than average total cost then

Â the ATC must be rising and if marginal cost is less than ATC,

Â then average total cost must be falling.

Â Figure it this way.

Â If the production of an additional unit has a marginal cost greater than average cost,

Â then the production of that unit must drive the average up and conversely.

Â Here's the punchline.

Â It must be that only when marginal cost equals average total cost that the ATC

Â is at its lowest point.

Â Now check this out.

Â This is a very critical relationship.

Â It means that a firm searching for

Â the lowest average cost of production should always look

Â for the level of output at which marginal cost equals average cost.

Â To better understand this relationship,

Â study the curves in this figure for a moment.

Â Note that there is a small range Area B,

Â where average cost is falling and average variable cost is rising.

Â Why is this important?

Â Simply because when we wedge the concept of marginal cost,

Â with the concept of marginal revenue,

Â and we will do so in the next lesson.

Â You will see that the firm is then able to determine if it is

Â profitable to expand or contract its production level.

Â In fact, the analysis in the next several lessons will

Â center on precisely these types of marginal calculations.

Â That's why learning these nuts and bolts concepts now is so

Â important and that completes our exploration of short run cost analysis.

Â So, when you are ready,

Â please move on to the next module in long run cost analysis.

Â