1 14. Marginal and Incremental Costs Essays: 1. What is the relationship between average and marginal cost when unit costs are minimized? Explain. 2. Discuss marginal and incremental cost. Why do economists argue that it is desirable to focus on marginal costs (and benefits?) Average and Marginal Costs Unit costs are minimized when average cost is equal to marginal cost. Why? Imagine the average weight of the people in a classroom. If a small child should enter the room. Assuming he or she is lighter than the average of the persons in the room, the average weight of the people in the room would fall. On the other hand, suppose a big lineman from a football team should enter the room. Assuming that person was heavier than the average of the persons in the room, the average weight would rise. When output is very small, then average cost will be extremely high. For example, if there is but one unit of output, then the entire fixed cost is included in the average cost of that one unit of output. It is very likely that marginal cost will be less than average cost and so expanding output will result in falling average costs. If marginal cost is increasing, then marginal cost must eventually rise above that falling average cost and average cost will begin to rise. That implies that the average cost (unit cost) will be at its lowest point when it is equal to marginal cost. Marginal and Incremental Analysis In the late 19th century, economists discovered that when making decisions, it is sensible to focus on the additional costs (and benefits) that result from a particular decision. This was called marginal analysis. By focusing on the additional costs and additional benefits resulting from a decision, one is automatically focusing on opportunity costs and avoid getting confused by factors that are irrelevant. For example, in the situation of considering an increase in production by one unit, it is the increase in cost that results that is of special interest. Suppose to produce one more unit of output, $325 dollars worth of additional labor and materials are needed. Perhaps it will be necessary to do a little more maintenance on the machinery and replace it a little sooner. Suppose that is worth $5. So the marginal cost is $330. Notice that one is ignoring “overhead” (fixed costs) or the amount initially paid for the machinery (sunk costs). These things aren’t relevant for determining exactly how much to produce. The marginal cost must be compared to whatever benefit might be generated by producing another unit of output. Usually, that would be the extra revenue generated from selling that output, which is called marginal revenue. If the marginal revenue is greater than the marginal output, then the amount produced during each period of time should be larger. Most economists use the term “marginal cost” to refer to the change in cost that occurs with a decision. But some economists, especially those who especially love calculus, do insist on the definition of marginal cost as being the change in cost when output changes by one unit. They use the term incremental cost to refer to the change in cost that occurs when a particular decision is made. (I find this silly, since the units in which output is measured are basically arbitrary, but you need to know the terminology.) For example, suppose a wing is added to a factory and output is expanded 2 accordingly. How much would total costs increase? That incremental cost is what should be compared to the benefit of increasing the size of the factory. In that situation, of course, the amount that must be paid for the factory wing, the amount that must be paid for the machinery, the materials and labor used to produce the output, must all be included in the incremental cost. (How much was paid for the existing portions of the factory and what is paid for machinery, labor and so on for that portion of the factory is not relevant.) In other words, the way to determine what is the opportunity cost for a decision is to look at what changes. That is, the marginal or incremental costs of the decision. Discussion: The cost per unit is $50 and you are selling for %60. You should produce more. Right? Discuss.
Pages to are hidden for
"marginal"Please download to view full document