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In an economic evaluation, the amount of money spent on a certain activity that involves the production of a good, a service or the development of an activity with social value is called cost or cost . Several parameters can intervene in the determination of the cost, namely: the marginal cost, the total cost, the fixed cost, the total variable cost, the average total cost, the average fixed cost or the average variable cost. These parameters depend on the amount of product that is generated in the production process. In this article we will focus on the relationship between marginal cost and average total cost.
Marginal cost is the cost a company needs to produce a good in addition to the amount it is producing. Average total cost is the total cost of producing a certain number of units divided by the number of units. The relationship between average and marginal cost can be easily explained by a simple analogy.
Instead of thinking about the costs of a productive process, let’s think about the qualifications of a series of exams. Suppose that the average grade that we have when we are studying a certain subject is 85. If an 80 grade was obtained in the next exam, this grade would lower the average and the new average grade that we would have in this subject would be something less than 85. Said otherwise, the average rating would decrease. If a grade of 90 were obtained on the next exam, this new grade would raise the average, which would then be slightly higher than 85. In other words, the average grade would increase. And if a score of 85 was obtained on the new test, the average would not change.
Going back to the cost of production analysis, let’s think of the average total cost of manufacturing a certain number of products as the average score, and the marginal cost as the score on the next test.
It is common to think of marginal cost as the incremental cost associated with the last unit produced, but marginal cost can also be interpreted as the incremental cost of the next unit to be produced. This distinction becomes irrelevant when calculating the marginal cost associated with very small changes in the quantity produced in a productive system that involves a large volume of product.
Following the analogy of the student and the exams, for a certain quantity of product the average cost will decrease when the marginal cost is less than the average total cost and, conversely, it will increase when the marginal cost is greater than the average total cost. The average total cost will not change if the marginal cost associated with a certain quantity of product is equal to the average total cost of producing that quantity.
The marginal cost curve and the average total cost curve
Let us remember that all the parameters associated with the cost evaluation of a production process depend on the amount of product generated by the process. Therefore, the usual way of studying these parameters is with curves or mathematical functions that show the relationship of the parameter with the variable Q, amount of product.
The production processes of most companies tend to decrease the marginal cost associated with labor and also to decrease the marginal cost associated with capital investment, the combination of which makes the total marginal cost tend to decrease. But, depending on the production system, there will be a range of the variable Q in which increasing the amount of product increases the marginal cost. The following figure shows a typical marginal cost variation curve associated with the variation in the quantity of product Q, where it can be seen that for some values of Q the marginal cost decreases as Q increases but in another range the marginal cost increases as Q increases. increase Q. In other words, the marginal cost curve is decreasing for small values of Q and then increasing,
The average total cost includes the fixed cost of production, those costs that do not depend on the quantity of goods that are produced; It is the cost incurred by the production system even when no good is produced. Marginal cost does not consider fixed costs, so average total cost is greater than marginal cost when few goods are produced, as shown in the figure above.
As we saw in the analogy, average cost will decrease if marginal cost is less than average cost, but then it will start to increase when marginal cost is greater than average cost. Therefore, the curve that expresses the variation of the average cost with the quantity of product Q will also decrease for small values of Q and then will increase, having a minimum value for a certain value of Q. By the previous reasoning, this value The minimum of the average total cost curve will coincide with the point of intersection with the marginal cost curve, as shown in the figure. This is because, as we saw in the analogy, average total cost and marginal cost have the same value at the point where average total cost tends neither to increase nor to decrease.
The relationship between average variable cost and marginal cost
Another important parameter when doing a cost evaluation is the variable cost. The total variable cost is the cost absorbed by the production system when a certain quantity of products is produced. It is the difference between the total cost and the fixed cost. And the average variable cost is the total variable cost divided by the amount of product generated.
A similar relationship exists between marginal cost and average variable cost as there is with average total cost. When marginal cost is less than average variable cost, average variable cost decreases, and when marginal cost is greater than average variable cost, average variable cost increases. In some cases the average variable cost also has a decreasing form for small values of Q and then increasing.
The average total cost in a natural monopoly
A natural monopoly is the case of a company that can generate all the production that a market can absorb at a lower cost than the one that would arise from the competition of several companies. This is the case of basic public services.
Because the marginal cost of a natural monopoly does not increase with the amount of output, the average total cost in this case has a different curve than we saw before. In the case of a natural monopoly, the average total cost curve is always decreasing, and has no minimum; in all cases, the more produced, the lower the average total cost.
Sources
E. Bueno Campos E., Cruz Roche I., Durán Herrera JJ Business economics. Analysis of business decisions . Pyramid, Madrid, Spain, 2002. ISBN 84-368-0207-1.
Omar Alejandro Martínez Torres, OA Economic analysis . Astra editions, Mexico, 1984.
