What this lesson teaches
I can explain a firm's cost and revenue concepts in the short run and the long run.
Syllabus 9570, 2.2.2(a). Cost and Revenue: Firms' cost and revenue concepts in the short run and long run
Make a guess
Your average over four tests is 70. You score 90 on the fifth. What happens to your average?
- It rises, because the new mark is above the average.
- It falls, because the fifth test is only one of five.
- It stays at 70, because averages change slowly.
Show the answer
It rises, because the new mark is above the average.
A marginal value above the average pulls the average up. In the same way, a unit whose marginal cost is above average cost raises average cost.
Average cost is cost per unit; marginal cost is the cost of one more unit, and MC cuts AC at its lowest point.
Average cost (AC) = TC / output. It is made up of average fixed cost (AFC) and average variable cost (AVC).
Marginal cost (MC) is the extra cost of producing one more unit.
In the short run, MC first falls and then rises, because adding more workers to fixed machines eventually makes each extra worker less productive (diminishing marginal returns).
When MC is below AC, it pulls the average down. When MC is above AC, it pulls the average up. So MC cuts AVC and AC at their lowest points.
- AC
- TC / Q = AFC + AVC.
- MC
- Extra cost of one more unit.
- Key rule
- MC cuts AVC and AC at their minimums.
| Batches | TC | AC | MC |
|---|---|---|---|
| 0 | $18 | - | - |
| 1 | $28 | $28 | $10 |
| 2 | $42 | $21 | $14 |
| 3 | $60 | $20 | $18 |
| 4 | $84 | $21 | $24 |
| 5 | $114 | $22.80 | $30 |
Worked example: The cost of a third batch
The workshop's total cost is $42 for 2 batches and $60 for 3.
- MC of the 3rd batch: $60 - $42 = $18.
- AC at 3 batches: $60 / 3 = $20.
- AVC at 3 batches: $42 / 3 = $14 (variable cost is $60 - $18).
- MC ($18) is below AC ($20), so the 3rd batch pulls AC down.
Watch out for this
Marginal cost is the average cost of all units.
MC is the extra cost of the last unit only. It can be above or below the average.
Check your understanding
A firm's AC is $10 and the MC of the next unit is $14. What happens to AC if it produces that unit?
- AC rises.
- AC stays at $10.
- AC falls.
Show the answer
AC rises.
Right. An extra unit costing more than the average pulls the average up.