ECON101: Principles of Microeconomics (2021.A.01)

The cost of producing a firm's output depends on how much labor and capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.

We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost. Average cost is the cost on average of producing a given quantity. We define average cost as total cost divided by the quantity of output produced.

$A C=T C / Q$

If producing two widgets costs a total of $44, the average cost per widget is

$\$ 44 / 2=\$ 22$

per widget. The other way of measuring cost per unit is marginal cost. If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced. More formally, marginal cost is the cost of producing one more unit (or a few more units) of output. Mathematically, marginal cost is the change in total cost divided by the change in output:

$M C=\Delta T C / \Delta Q$

If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is

$\$ 44-\$ 32.50=\$ 11.50$

We can see the Widget Cost table redrawn below with average and marginal cost added.

Table 6. Extended Cost Function for Producing Widgets

Note that the marginal cost of the first unit of output is always the same as total cost. Figures 3a and 3b show the graphs of average and marginal cost respectively. The typical shape of each is a U-shape, with average/marginal cost falling at low levels of output and rising at higher levels of output.

Figure 3. Average and Marginal Cost Curves. Figure 3a shows the average cost of producing widgets based on the data in Table 6. Figure 3b shows the marginal cost of producing widgets. Both average and marginal cost curves typically are U-shaped.