CFA Practice Question

There are 539 practice questions for this study session.

CFA Practice Question

Which of the following statements best explains why the average total cost of a firm is U-shaped?
A. Marginal cost is high for low output levels and average fixed cost is high for high output levels.
B. Average fixed cost is high for low output levels and marginal cost is high for high output levels.
C. Marginal cost is low for low output levels and average fixed cost is low for high output levels.
Explanation: ATC = AFC + AVC = (TFC + TVC)/Q. First we focus on average fixed costs, TFC/Q. Since the cost is fixed, the smaller Q is the larger ATC will be. However, as higher output levels are reached, there is a point where the incremental change in total cost for each incremental change of quantity will start to increase. That is, MC = DTC / Dq will start to get bigger, to the point where MC > ATC in such a way that ATC gets bigger. So on either extreme (low Q, high Q), ATC will be high.

User Contributed Comments 5

User Comment
sbajaj Can someone explain to me what's wrong with the last choice?
bluefin209 I think it's because marginal cost is high for low output levels and becomes lower when output levels increase in accord with the principle of diminishing returns.
bobert It is for this reason:
If you are a firm with fixed costs of 500 and you produce 1 unit, that is an AFC of 500, so your lower output has a high fixed cost as opposed to producing 500 units which would have an AFC of just $1. However, the MC curve like the ATC curve are both "U" shaped, so at the beginning, you have high marginal costs, where as it decreases, and then eventually is brough back up with more weight on AVC.

Part of the last choice is half right, the second half.
achu while bobert is right, look at the question carefully: why is the curve U SHAPED? While low fixed costs at high output levels is true, that is not why curve is U shaped. Even if the last choice eliminated the first half of the answer, the second part wouldn't explain the U shape curve as well as the correct answer.
nayagan good explanation achu
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