Cost Concepts 2: The Relationship between Total Cost, Average Cost and Marginal Cost

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Reviewed by Omotolani Ajileye

The Relationship Between Total Cost (TC), Average Cost (AC) and Marginal Cost (MC)

Understanding the relationship between total cost, average cost and marginal cost is crucial for analyzing production expenses as output changes.

• Total Cost refers to the overall expense incurred in producing a given level of output. This cost typically increases as more goods are produced because additional resources are required.

• Average Cost is the cost per unit of output. It is calculated by dividing total cost by the number of units produced.

• Marginal Cost is the additional cost incurred when producing one more unit of output. This cost directly influences the total cost as production increases.

The Impact of Marginal Cost on Average Cost

• When marginal cost is lower than average cost, it pulls the average cost down, causing the average cost curve to fall.

• When marginal cost exceeds average cost, it pushes the average cost upwards, making the average cost curve rise.

• When marginal cost equals average cost, the average cost reaches its lowest point. This is where the marginal cost curve typically intersects the average cost curve, which helps firms determine the most efficient level of production and manage costs effectively.

Relationship Between VC, MC, AVC, ATC and AFC

The relationship between variable cost (VC), marginal cost (MC), average variable cost (AVC), average total cost (ATC) and average fixed cost (AFC) is integral to production analysis:

• Variable Cost increases as output rises because more resources such as raw materials and labour are needed.

• Marginal Cost is mainly influenced by changes in variable cost since fixed costs do not change with output. Initially, marginal cost decreases due to better resource use but later rises due to diminishing returns.

• Average Variable Cost behaves similarly: it decreases as efficiency improves but increases when production becomes less efficient.

• Average Total Cost is the sum of average fixed cost and average variable cost. Average fixed cost decreases as output increases, as the fixed cost is spread across more units. As a result, the average total cost curve lies above the average variable cost curve but follows a similar U-shape.

Role of Marginal Cost

Marginal cost plays a key role in determining both average variable cost and average total cost. When marginal cost is lower than these averages, the averages decrease. When marginal cost exceeds these averages, the averages increase. Marginal cost always intersects both the average variable cost and average total cost curves at their lowest points.

Economic Costs: Explicit and Implicit

• Explicit Costs are the direct payments made by a firm to obtain the resources required for production. These costs involve actual cash outflows and are clearly recorded in financial records. Examples include wages, rent, raw materials, electricity bills and interest on borrowed capital.

• Implicit Costs represent the value of resources owned and used by the firm without direct monetary payment. These costs reflect the income the firm could have earned if those resources were used for another purpose. For example, if a business owner uses their own building instead of renting it out, the rent they could have earned is an implicit cost.

Opportunity Cost vs. Money Cost

• Opportunity Cost refers to the value of the next best alternative that must be given up when a choice is made. For instance, if a farmer uses land to grow rice instead of maize, the maize that could have been produced becomes the opportunity cost of producing rice.

• Money Cost refers to the actual amount of money spent during production. It includes expenses like wages, raw materials and utility bills. While opportunity cost focuses on the value of the sacrifice made, money cost focuses on the actual financial expenditures involved in production.

Short Run and Long Run Costs

• In the short run, at least one factor of production is fixed and cannot be easily changed. For example, a firm may not be able to immediately increase the size of its factory. In the short run, both fixed and variable costs exist.

• In the long run, all factors of production are variable, allowing firms to adjust every input used in production. This means firms can expand or reduce their plant size, buy more machines, or hire additional workers.

The Difference Between Economists’ and Accountants’ View of Costs

• Accountants focus only on explicit costs, which are direct monetary payments like wages, rent and utilities. These are recorded in financial statements.

• Economists, on the other hand, include both explicit and implicit costs. They take into account the opportunity costs of using resources owned by the firm, such as the owner’s time or capital. Economists aim to measure the true cost of production, reflecting all resources used, while accountants focus on cash outflows only.

Cost of Production Schedule

A cost schedule shows different costs at varying levels of output. Here’s an example:

From this table, students can calculate Average Cost, Marginal Cost and Average Variable Cost.

Read also:Understanding the Different Economic Systems in the Society

Final Thoughts

• Average and marginal costs have important relationships that affect production efficiency.

• Economists consider both opportunity and implicit costs, while accountants focus mainly on explicit costs.

• Cost schedules and formulas are valuable tools for analyzing production efficiency.

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