AVERAGE AND MARGINAL COST

As the owner of her firm, Thelma has to decide how much to produce. A key part of this decision is how her costs will vary as she changes the level of production. In making this decision, Thelma might ask her production supervisor the following two questions about the cost of producing lemonade.

• How much does it cost to make the typical glass of lemonade?
• How much does it cost to increase production of lemonade by 1 glass?

To find the cost of the typical unit produced, we would divide the firm’s costs by the quantity of output it produces. For example, if the firm produces 2 glasses of lemonade per hour, its total cost is \$3.80, and the cost of the typical glass is \$3.80/2, or \$1.90. Total cost divided by the quantity of output is called average ,total cost. Because total cost is the sum of fixed and variable costs, average total cost cap he expressed as the sum of average fixed cost and average variable cost. Average fixed cost is the fixed cost divided by the quantity of output, and average variable cost is the variable cost divided by the quantity of output.

Although average total cost tell the cost of the typical unit, it does not tell Us how much total cost will change as the firm alters its level of production. The last column in Table 2 shows the amount that total cost rises when the firm increases production by I unit of output. This number is called marginal cost. For example, if Thelma increases production from 2 to 3 glasses, total cost rises from \$3.80 to \$4.50, so the marginal cost of the third glass of lemonade is \$4.50 minus \$3.80, or \$0.70. In the table, the marginal cost appears halfway between two rows because it represents the change in total cost as quantity of output increases from one level to another.

Here the Greek letter delta, represents the change in a variable. These equations show how average total cost and marginal cost are derived from total cost. Average total cost tells  the cost of a typical unit of output if total cost is divided evenly over all the units produced. ‘Marginal cost tells us the increase in total cost that arises from producing an additional unit of output. As we will see more fully in the next chapter, business managers like Thelma need keep in mind the concepts of average total cost and marginal cost when deciding how much of their product to supply to the market.

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