7.3, production, the cost curve for Beautiful Cars. Beautiful Cars is an imaginary company
that produces luxury cars and the strategy of this company is to produce a small number
of cars but try to make a large profit on each car produced. So let's get inside this
factory. This is the assembly line for Beautiful Cars. This company incurs two types of costs:
the first type is the fixed costs, and as the name suggests, these costs are independent
of the number of cars produced - an example of fixed costs are the costs of research and
development that go into designing new cars, or the advertisement cost of promoting a new
car, or the cost of patenting a new technology that this firm is using to produce cars; the
second type of cost is the variable costs, and as the name suggests these costs vary
or increase as we produce more and more cars. A good example of it is the car components:
as you produce more cars, you are going to spend more on car components, therefore your
variable costs go up. The combination of fixed costs and variable costs give you the total
cost. Now let's go back to our textbook and scroll down to see the concepts we talked
about depicted in a graph. Here the x-axis represents the number of cars produced per
day, and the y-axis represents the costs. The purple line depicts the total cost of
production and as you can see if our company does not produce any car, it still has to
pay a fixed amount of costs which is represented by F here. Now we introduce a new concept
which is the average cost of production, which is the total cost of production divided by
the number of cars produced. For instance, if our company decides to produce 20 cars,
the total cost, which is $80000 divided by 20 will get $4000, the average cost of producing
a car. If our company decides to increase its production further from 20 to 40 cars
per day, then the average cost declines from $4000 to $3400. But if we decide to increase
our production further from 40 to 60, our average cost starts to increase from $3400
to $3600. So if we depict our average cost curve, the blue curve here, we see a U shape.
At the beginning the average cost starts to decline, why? Because at low levels of production
the fixed costs dominate the total costs. But at some stage we start to reach the full
capacity of our given factory, and in order to keep up with production we will have to
put more pressure on our production line, and as a result we will have more errors and
breakdowns and the average cost increases. So this was average cost, and it is a very
useful concept in business. The managers of Beautiful Cars constantly think about what
price they will charge for Beautiful Cars, and how much these cars cost to produce on
average. So let me scroll down and introduce another concept, and that is called the marginal
cost. Marginal cost is the cost of producing one more car. Now you might ask who in reality
thinks about this concept. Does Beautiful Car think about the cost of producing one
more car? Perhaps not, but when they are making a decision about whether to expand the business
or not, Beautiful Cars think about the cost of this expansion, how much this expansion
adds to their costs. So in reality businesses use this concept at the back of their minds.
Now let's go back to our assembly line. We can think of the marginal cost in this way.
How much would the production of the first car add to our total costs? How much would
the production of the second car add to our total costs? And we can do this all the way
until the final unit which is the 20th car. Now remember, all these cars are identical
and cost the same to produce. When we talk about marginal cost we are simply talking
about the cost of expansion of our production, we are not talking about the cost of a particular
car. Now we know from out textbook that the marginal cost of producing the 20th car is
$2200. Producing the 20th car would add $2200 to our costs, and if we look at our final
costs, the marginal cost represents the slope of this curve, how much producing the 20th
car would add to our total costs. And as you can see, the slope of our total cost increases
as we expand production, and that means our marginal cost is upward sloping. Now the upward-sloping
marginal cost curve means that as we move along in our assembly line from the first
car produced to the last car produced, the cost of producing an additional car goes up
and up. And that's because of diminishing returns to factors of production, more specifically
here, diminishing returns to labour. To understand diminishing returns let's think about this
example. When our factory starts, it has a fixed set of machinery. To produce the first
batch of cars our company needs to hire three workers. Now these workers are very productive
because they have a lot of machinery to work with. But to further expand its production,
our company needs to hire the second group of workers. Now these two groups of workers
need to share the same amount of machinery with each other, therefore productivity goes
down. Again, to further expand you need to hire more workers, now these three groups
of workers need to share the fixed machinery. Now you get the idea: if you have a fixed
set of machinery and you keep adding labour to your factory, the average productivity
of labour is going to go down. Therefore the cost of expanding your production goes up
and up - the marginal cost goes up and up. Finally, let me draw your attention to one
thing in the graph here. Here the marginal cost curve intersects the average cost curve
at a point where average cost is the minimum. And this has to be true by definition, why?
Because remember this is average, and this is what we are adding to average. Let me focus
on an example. The average cost of 20 cars is $4000. What happens if we add $2200 to
$4000? It's going to drag our average further down. So, as long as the marginal cost curve
is below the average cost curve, is going to drag the average down, where both these
things are the same. Here the thing we are adding to the average is the same as average.
What is going to happen? Nothing. Here what we are adding to average is above average,
so it's going to drag average up.