Average cost and marginal costs (1)

Activities this week have already discussed in detail the concept of average cost and the average cost curve. Another measure of cost is marginal cost. Marginal cost is the change in total cost incurred as a result of producing an extra unit of output. Marginal cost and average cost are closely related.

To see how marginal cost and average cost are related, let's think about the average height of people in a room. Consider how the average height changes when an extra person enters. For instance, if the room contains just three people, we can calculate the average height of people in the room.

Suppose a fourth person enters. We can call this extra person the marginal person. If the marginal person is shorter than the average height of people already in the room, then the average height of people will fall. We can use the same idea to look at what happens to average cost in a firm when an additional unit of output is produced.

Let's consider a typical average cost curve for a firm. If average cost is falling as a firm increases its quantity of output, then the cost of each marginal unit of output must be less than the average cost. For instance, at output Q1, the marginal cost must be less than the average cost. The marginal cost, the cost of producing an additional unit, lies below the average cost curve.

When average cost is rising as output increases, then marginal cost must be greater than average cost. For instance, at output Q2, the marginal cost must be above the average cost curve. With every additional unit of output, average cost increases. Marginal cost is greater than average cost.

Average cost and marginal cost are only equal when average cost is no longer falling, and has not started to rise. In other words, average cost is at a minimum. Average cost is at a minimum when output is Q3.

As a quantity less than Q3, marginal cost is less than average cost. Marginal cost can be drawn as a curve like this. To the right of Q3, marginal cost is greater than average cost, and the marginal cost curve is drawn like this. The marginal cost curve intersects the average cost curve where average cost is at a minimum.

Now we have described the marginal cost curve whose shape and position are determined by the shape of the average cost curve. As we will see later in the block, economists use marginal cost to analyse firms' decisions about how much output to produce.