In this video we’re going to focus on the concepts of marginal and average cost.
In order to do so, we need to first distinguish between fixed and variable costs.
Once we’ve done that, we’ll use cost information to calculate marginal and average cost.
Simply put, fixed costs are costs that do not change in the short-run and do not vary
with output.
The image here is of a pizza restaurant.
Assuming the pizza shop manager pays the same rent every month then the amount of pizzas
produced doesn’t really matter.
If they produce nothing or a lot, the rent is the same.
Other examples of fixed costs include monthly insurance payments and salary payments.
Labour and ingredients are considered variable costs, which are costs that do change in the
short-run due to the fact that more variable inputs are needed to increase production.
In the image on the right we see a pizza and some of the ingredients needed to make it
below the image.
Included are tomatoes, mushrooms, flour, eggs and cheese.
As the number of pizzas made increases, the amount of these ingredients increases as well.
Beyond ingredients, firms can have other variable costs such as electricity and raw material
costs.
To arrive at our marginal and average cost we have to work our way there from labour
and production information.
The first column is for our units of labour, which increases from 1 to 10 workers at the
restaurant.
The units of capital are held constant because they are assumed to be fixed in the short
run.
The total product as a combination of variable and fixed factors is listed in the third column.
The fixed costs total $100 and do not increase as output does.
This is our cost for the restaurant, capital and other fixed equipment per month.
Obviously it’s a low number but I’ll use it for simplicity’s sake.
Variable costs are simplified to just reflect the increase in the units of labour.
Each unit of labour is $20 per month per worker.
Again - a simplification for this example.
However, as output rises, variable costs rise.
We multiply the $20 by the units of labour to arrive at our total variable costs.
The sum of our total fixed costs and total variable costs is our total cost of production.
This last column represents the sum of the two cells preceding it to the left.
$100 plus $20 equals $120.
We complete the rest of the table using this information.
To move forward from here we have to factor in our total product.
Let’s see how to use that next.
I’ve removed the columns for variable cost and fixed cost to make room for marginal cost
and average total cost.
You should notice that as labour increases, more product is made.
If you recall our previous lesson, you’ll notice that total product increases dramatically
in the beginning, but as diminishing returns set in, less and less is being added to the
total.
Why does this matter?
It matters because we need to consider the change in our total product to be able to
calculate marginal cost.
Marginal cost is calculated by looking at the difference in total cost divided by the
change in total product.
This allows us to consider the cost of producing one more unit.
Remember, we assume that firms are more concerned about marginal production than average production.
To calculate marginal cost at an output of 5, we need to divide the change in total cost
by the change in total product.
That means we need to divide 120-100/5-0.
This gives us 20/5 which equals a marginal cost of $4.
Let me show you how I did that.
We start at the top and work our way down.
As total cost increases from 100 to 120, that is an increase of $20.
The total product has now increased from 0 units to 5 units.
Dividing $20 by 5 units we find our marginal cost at this level of production to be $4.
If you complete the table all the way through you’ll see that marginal cost initially
declines, bottoms out and starts to rise.
This is linked to the law of diminishing returns which should be evident to you from this table
as marginal product also declines.
Compare that for a moment before I move on to average total cost.
Average total cost is a somewhat simpler calculation.
You don’t need to calculate any changes.
Just divide the total cost by the total product.
Similarly you should see average cost drop initially, bottom out and then rise.
Why it doesn’t match marginal cost exactly will be illustrated in the next video.
For now just understand the basic calculation.
Given a similar table you should be able to deduce it for yourself.
If you need some help, stop the video and perform the calculations yourself and see
if you can get them to match my numbers.
If you can’t get them correct, leave a note in the comments and I’ll try to explain
further.
Hopefully this video has given you a stronger understanding of the difference between fixed
and variable costs.
With some additional cost information you should now be comfortable attempting to calculate
marginal and average costs.
In our next video we’ll see how they look on a diagram and the logic behind their shapes.
If you have any questions or comments, leave them below.
If you need to get in touch with me you can email me at enhancetuition@gmail.com.
That’s us done for now and I will see you in the next one!