Question

What are the different types of costs (fixed, variable, total, average, marginal) and how are they related? Explain with the help of diagrams.

Hint:

TC=TFC+TVC; AFC falls continuously; AVC, AC, MC are U-shaped; MC cuts AVC and AC at their minimum points.

Answer 1

Step 1: Total Fixed Cost (TFC):
TFC is the cost that does not vary with the level of output (rent, insurance) — it must be paid even at zero output. Graphed against output, TFC is a horizontal straight line.

Step 2: Total Variable Cost (TVC):
TVC is the cost that changes directly with output (raw material, labour). Due to the law of variable proportions, TVC initially rises at a decreasing rate, then at an increasing rate, giving it an inverse-S shape starting from the origin.

Step 3: Total Cost (TC = TFC + TVC):
TC has exactly the same shape as TVC, but shifted vertically upward by the constant amount TFC — the TC and TVC curves are always a fixed vertical distance (TFC) apart, and never touch.

Step 4: Average Fixed Cost (AFC = TFC/Q):
Since TFC is constant, AFC keeps falling continuously as Q rises (this is called "spreading the overhead") — graphically, AFC is a rectangular hyperbola that approaches but never touches either axis.

Step 5: Average Variable Cost (AVC = TVC/Q) and Average Cost (AC = TC/Q = AFC+AVC):
Both are U-shaped, first falling (increasing returns) then rising (diminishing returns), due to the law of variable proportions. AC lies above AVC by exactly AFC at every output, and since AFC keeps shrinking, the AC and AVC curves keep getting closer together (converging) as output rises, though AC never actually meets AVC.

Step 6: Marginal Cost (MC = change in TC / change in Q):
MC is also U-shaped, reflecting the same law of variable proportions. Crucially, MC cuts both the AVC curve and the AC curve exactly at their minimum points, always from below — this is a mathematical property (marginal always pulls the average toward itself: MC below average pulls the average down, MC above average pulls it up, so they intersect precisely where average is at its lowest).

Step 7: Diagram description:
On one graph with Output on the x-axis and Cost on the y-axis: draw AFC continuously falling (never meeting the axes), AVC and AC as U-shaped curves with AC above AVC and the gap narrowing rightward, and MC as a U-shaped curve that starts below AVC/AC, dips to its own minimum earlier (since MC responds to changes fastest), then rises and cuts AVC at AVC's lowest point, and continues up to cut AC at AC's lowest point.

Final Answer:
TFC (constant) and TVC (inverse-S) sum to TC; AFC (falling), AVC and AC (both U-shaped, AC above AVC) are per-unit costs; MC (U-shaped) cuts both AVC and AC at their respective minimum points from below.