Is Average Variable Cost a Good Proxy for Short-Run Marginal Cost and Why is it Important?

Average variable cost is often used as a proxy for short-run marginal cost in empirical studies of manufacturing firm behaviour. Assuming that average variable cost is equal to marginal cost, Cowling and Waterson (1976) derive a model that links industry structure to the industry price-cost margin and Areeda-Turner (1975) provide a test of predatory pricing. However, the research on the relationship between average variable cost and short-run marginal cost mainly comes from survey studies. This paper employs a supply relation similar to Bresnahan's (1982) in order to estimate industry marginal cost divided by industry average variable cost (MC/AVC) for 89 four-digit Australian manufacturing industries during 1971 to 1984. The 3SLS results indicate that MC/AVC is not significantly different from one in 40 percent of industries, but is cyclical in only 30 percent of industries. This suggests that industry average variable cost multiplied by a constant can be used as a proxy for industry marginal cost for a large number of industries over a short period.