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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
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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.

				
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posted:11/25/2011
language:English
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