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The relationship between marginal and average costs

Economics
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Dec 8th, 2014

Marginal cost is best understood as the cost of the next item produced or purchased. This may sound simple but it is a slightly more complicated term but extremely useful in the study of economics. 

For example - the more of a product you produce it is likely that the cost of producing each item changes. In fact it is likely to fall. If you wanted to produce a widget, you would first need to rent a factory, buy some machinery and some raw material. If you wanted to produce another widget you could reuse the machinery that and perhaps some left over material and therefor the cost of producing the second widget is slightly lower. As you get better at producing widgets (maybe you learn more skills or negotiate cheaper material costs) your marginal cost will fall such as the cost of producing one more widget is much lower than the cost of producing your first widget. 

Average cost is slightly different. It is the sum of all of the costs you have incurred producing widgets divided by the number of widgets you have produced. For example, if you produce 2 widgets and the cost of the first was $20 and the cost of the second widget was $10 then the average cost is ($20 + $10) / 2 = $30 / 2 = $15

In this example the marginal cost is the cost of producing the 3rd widget. If the cost of producing the 3rd widget is $3 then the marginal cost is $3. If you produce this extra widget then your total costs rise by $3 to $33 ($20+$10+$3) and the number of widgets rises to 3. In this case your average cost will then become $33 / 3 = $11.

Dec 25th, 2014

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