average cost

Average cost is the cost per unit — what each item costs you on average to make. Spend 3,000 to bake 5,000 loaves and your average cost is 3,000 / 5,000 = 0.60 a loaf. It is the number a shopkeeper instinctively reaches for when asking 'what does each one cost me, and so what must I charge to come out ahead?'

Average cost is total cost divided by the number of units. Because total cost has two parts, average cost does too: average fixed cost (the spread-out rent, which falls steadily as output rises, since the same fixed sum is shared among ever more units) plus average variable cost (which is fairly flat then rises with diminishing returns). Add them and the average cost curve is typically U-shaped. It falls at first as the heavy fixed cost gets spread thinner and thinner; it bottoms out at the most efficient scale; then it rises as diminishing returns make extra units increasingly costly. The lowest point of that U is the firm's most efficient output — produce there and each unit is as cheap as it can be.

There is a beautiful and exact relationship with marginal cost: marginal cost always cuts the average cost curve at its lowest point. The logic is just arithmetic — when the cost of one more (marginal) is below the running average, it drags the average down; when it is above, it pushes the average up; so the average stops falling and starts rising precisely where marginal equals average. Average cost matters because comparing it to the selling price tells the firm at a glance whether it is making a profit (price above average cost), breaking even (price equal to it), or losing money (price below it) on each unit.