In our last module, we worked our way through the concepts of fixed costs, variable costs, total costs, and marginal cost, as a way of understanding short run cost analysis. We need to continue that journey now by introducing the final three columns in our table, for average fixed cost, average variable cost, and average total cost. Note that these three columns are simply derived by calculating averages using columns one through four and the formulas in the table. For example, the average fixed costs for an output of five is simply fixed costs divided by five for a total of 10. So to make sure you grasp this idea, see if you can fill in the question marks in the table. Just pause the presentation now and do so. Did you get this exercise right? Okay. Now, take a look at this figure, which provides a graphical interpretation of the very important relationships between marginal cost and our three main average cost measures: average fixed costs, AFC, average variable costs, AVC, and average total costs, ATC. Please study this figure carefully now for a few minutes as you try to answer these questions. Why does the AFC curve slope downward and approach zero on the horizontal axis while the AVC curve approaches the ATC curve? Why does the marginal cost or MC curve intersect both the AVC and AC curves at their minimums? Please pause the presentation now to contemplate these questions, which actually have very important implications for operations and supply chain management. Okay. Let's start with the easiest question. Why does the AFC curve slope downward and approaches zero on the horizontal axis? That is simply because as a firm's output increases, it spreads its fixed costs over a larger number of units so average fixed costs must fall. This is an important insight because one of the benefits of increased production volume is to the spread fixed costs over more and more units and figuring out ways to do that is an important part of the planning process. I should also point out here that in complex organizations, the accounting team often has a very difficult time properly allocating the fixed costs of a firm over multiple activities of the firm. Get that allocation wrong, and you can sometimes provide a very skewed picture of what portions of the firm's activities are profitable and which may not be. Next question, why does the average variable cost curve approach the average total cost curve? Of course, because as average fixed costs fall this must be the case. As for the hardest question, why is the marginal cost curve MC intersect both the AVC and AC curves at their minimums? First, let's refresh your memories as to why the ATC, AVC and MC curves slope first down and then up. It's the law of diminishing returns, right? As for why the MC curve intersects both the AVC and AC curves at their minimums, the answer lies in these key formulas. If marginal cost is greater than average total cost then the ATC must be rising and if marginal cost is less than ATC, then average total cost must be falling. Figure it this way. If the production of an additional unit has a marginal cost greater than average cost, then the production of that unit must drive the average up and conversely. Here's the punchline. It must be that only when marginal cost equals average total cost that the ATC is at its lowest point. Now check this out. This is a very critical relationship. It means that a firm searching for the lowest average cost of production should always look for the level of output at which marginal cost equals average cost. To better understand this relationship, study the curves in this figure for a moment. Note that there is a small range Area B, where average cost is falling and average variable cost is rising. Why is this important? Simply because when we wedge the concept of marginal cost, with the concept of marginal revenue, and we will do so in the next lesson. You will see that the firm is then able to determine if it is profitable to expand or contract its production level. In fact, the analysis in the next several lessons will center on precisely these types of marginal calculations. That's why learning these nuts and bolts concepts now is so important and that completes our exploration of short run cost analysis. So, when you are ready, please move on to the next module in long run cost analysis.