Wednesday, October 15, 2008

Will Increase In Fixed Costs Increase Both MC & AC?

This is another interesting issue to look at regarding the theory of costing. Most textbooks & economics websites do not provide sufficient information on this. It normally provides only the curve.

Before I explain, I hope that readers understand what is FC, VC, TC, AC & MC is. Brief definitions:

Fixed cost (FC): Costs that do not vary with amount of output produced. E.g. even though I may not be doing business that month, I still need to pay for rental or loan from banks etc

Variable cost (VC): Costs that vary with number of output. The more a firm produce, the more raw materials it need

Total cost (TC): Sum of both FC & VC

Average cost (AC): TC/ Q (cost per unit of output)

Marginal cost (MC): Additional increase in cost, due to extra one unit of output produced

Source of diagram:

Try to look at it mathematically. Look at the calculations below

5th unit, FC = RM 10, VC = RM 30, therefore TC = RM 40 and AC = RM8

6th unit, FC = RM 10, VC = RM 32, therefore TC = RM 42 and AC = RM7

Marginal cost (MC) from the 5th to 6th unit is (42-40) RM2

But when fixed cost increase, say to RM 15

At 5th unit, new TC = RM 45, therefore and AC = RM9

At 6th unit, new TC = RM 47, threfore and AC = RM7.83

BUT marginal cost (MC) from the 5th to 6th unit is (47-45) RM 2

Therefore when fixed cost increase, it will pull AC up, but has no effect on MC. This is because mathematical logic tells us that the similar increase actually cancels out each other

No comments: