Law of Variable Proportion - Production Analysis, Business Economics & Finance - CA CPT PDF Download

The following article will guide you to know why cost curve is “U” shaped.

The addition of fixed and Variable Cost gives us total costs, which when divided by the output give us Average Costs in the short period.

The nature of short period Average Cost Curve is ‘U’ shaped. To begin with, the Average Costs are high at low levels of output because both the Average Fixed Costs and Average Variable Costs are more.

But, as the level of output increases, the Average Costs fall more sharply due to the combined effect of the declining average fixed and Average Variable Costs.

This results from the use of indivisible factors and the reaping of internal economies of labour, technical, managerial, marketing etc. The Average Cost will continue to fall till they reach the minimum point which is the optimum point level of output. Once the optimum level of output is reached, Average Costs starts rising as more are produced beyond this level.

The rise in Average Variable Cost is more than off set by the small fall in Average Fixed Costs and hence the Average Costs rises quickly. This is due to the change of economies into dis-economies. This gives the short-run as well as long-run Average Cost Curve of the firm IP shaped.

The nature ‘U’ shaped short-run Average Cost curve can be attributed to the law of variable proportions. This law tells that when the quantity of one variable factor is changed while keeping the quantities of other factors fixed, the total output increases with an increasing rate and then declines with more than proportionate.

Thus, the Average Costs of the firms continue to fall as output increases because it operates under the increasing returns due to various internal economies. Due to the operation of the law of increasing returns the firm is able to work with the machines to their optimum capacity and as a consequence the Average Cost is minimum.

If the firm tries to raise output after that point by increasing the quantities of variable factors the fixed factors like machines would be worked beyond their capacity. This would lead to diseconomies of production and diminishing returns. The Average Costs will start rising rapidly. Hence, due to the operation of Law of Variable proportions the short-run as well as long-run Average Cost Curve is TJ shaped’.