Q.Explain the concept of Fixed Cost and Variable Cost. Derive Average Fixed Cost and Average Variable Cost with the help of a cost schedule.
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Start your 14-day free trial to unlock the full solution →Fixed Cost does not change with output, while Variable Cost changes directly with the level of output; dividing each by output gives Average Fixed Cost (which falls continuously) and Average Variable Cost (which is U-shaped). [The OR alternative explains the TR-MR relationship with a revenue schedule.]
MAIN PART
Fixed Cost (FC): Costs that do NOT change with the level of output in the short run — they must be paid even at zero output (e.g., rent of factory building, interest on borrowed capital, salaries of permanent staff). Total Fixed Cost (TFC) remains constant at all output levels in the short run.
Variable Cost (VC): Costs that change DIRECTLY with the level of output — they are zero at zero output and rise as output rises (e.g., cost of raw materials, wages of casual/daily labour, cost of power/fuel used in production). Total Variable Cost (TVC) rises as output rises.
Deriving AFC and AVC with a cost schedule:
| Output (units) | TFC (Rs.) | TVC (Rs.) | AFC = TFC/Q (Rs.) | AVC = TVC/Q (Rs.) |
|---|---|---|---|---|
| 1 | 60 | 20 | 60.0 | 20.0 |
| 2 | 60 | 30 | 30.0 | 15.0 |
| 3 | 60 | 45 | 20.0 | 15.0 |
| 4 | 60 | 68 | 15.0 | 17.0 |
| 5 | 60 | 100 | 12.0 | 20.0 |
Average Fixed Cost (AFC) = TFC / Q: Since TFC (Rs. 60) stays constant while Q rises, AFC falls CONTINUOUSLY as output increases (60 → 30 → 20 → 15 → 12) — this is the 'spreading overhead' effect, and the AFC curve is a smooth rectangular hyperbola, always falling but never reaching zero.
Average Variable Cost (AVC) = TVC / Q: AVC FIRST FALLS (60→... here 20.0→15.0→15.0) as increasing returns to the variable factor reduce the variable cost per unit, reaches a minimum, and then RISES (17.0→20.0) as diminishing returns set in — giving AVC its characteristic U-shape, directly reflecting the Law of Variable Proportions.
OR ALTERNATIVE — Relationship between Total Revenue (TR) and Marginal Revenue (MR):
Marginal Revenue (MR) is the addition to Total Revenue from selling one more unit: MR = TRₙ − TRₙ₋₁. Because MR is essentially the rate of change (slope) of TR, the behaviour of TR is fully governed by the sign of MR.
Revenue schedule (illustrative, e.g. under imperfect competition where price must be cut to sell more):
| Quantity (units) | Price (Rs.) | TR = P×Q (Rs.) | MR (Rs.) |
|---|---|---|---|
| 1 | 10 | 10 | 10 |
| 2 | 9 | 18 | 8 |
| 3 | 8 | 24 | 6 |
| 4 | 7 | 28 | 4 |
| 5 | 6 | 30 | 2 |
| 6 | 5 | 30 | 0 |
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