Two other costs that we need to consider are marginal and average costs.
Average costs are quite easy to understand. To work out the average cost for the firm we have to take the total costs and divide that by the units we have produced.
For the example of the dress firm then:
Total costs = Fixed costs + Variable costs
Total costs = (Factory, sewing machines, salaried labour) + (material costs, shipping costs, casual waged labour etc.)
Totals costs ÷ Q = ATC
So if total costs were $10,000 and we sold 1000 dresses the average cost per dress will be $100.
What then is the marginal cost? The marginal cost is the cost associated with producing one extra unit of production. In other words, the additional costs of producing the 1001st dress. This would be the additional variable cost of producing that extra 1001st unit.
The relationship between MC and AC
How do we explain the shape of the marginal cost curve?
Remember that the marginal cost curve is concerned with the additional cost of producing one more unit. So as we try to increase the production we must be changing some variable factor, for example how much casual labour we are using.
At first we may get increasing returns to the variable factor. This means although output is going up, marginal costs are falling. This will be caused by improving marginal productivity, the most likely reason for this is that the labour was in some way underutilised at lower levels of output, and output could be increased without raising costs. Think of someone who you have employed and paid fully for the days labour but who is only really needed for half the day. Now let us say we try to increase output. We could make this person work harder producing more dresses but we won’t have to pay them anymore, because they have already been fully paid for the day. So marginal productivity increases, but marginal cost will fall as our cost are being divided up by more output.
However after a certain amount of time, the only way to increase output is to increase the costs, hiring more labour or paying overtime. From this point the costs of producing each next unit will start to go up. The marginal cost of each unit increases as we increase production. This makes a lot of sense. To make more dresses we need to hire more labour and buy more material. This costs money.
What about the average cost curve. Remember the marginal is looking at the costs of the last unit. The average includes the costs of all the units. The average also includes the fixed costs of production. Obviously as we increase production the average cost of those fixed factors fall. Why, because the high fixed costs are being divided up by increasingly large number of units. As long as the marginal cost stay below the average the then the average will start to fall.
Why is that? Well imagine a room with lots of very tall people standing in it. These people represent the high fixed costs, you will be starting with a high average height. You then get everyone else you know to stand outside the room. Get them to line up from smallest to highest. Then let them in one at time. Each person coming through the door is the marginal person. At first they will all be below the average height, therefore the average height will start to fall. (150cm is obviously shorter than an average of 180cm, as a result that person who is only 150cm tall will bring down the average height.)
As people keep filing into the room they start to get taller, you have used up all your small people, but they are still below the average so the average keeps falling. At some point the marginal person will be the same height as the average height. (The marginal person is 165cm tall and the average height in the room has now fallen to 165cm). After this the people coming into the room are taller than the average height of the room. (166cm compared to 165cm average) Since this person is above the average then the average will start to rise. And the average will keep rising because each next person is taller than the one before. This continues as long as the marginal height is above the average.
Relating this back to costs of our dress firm. As long as the marginal cost of producing each dress is below the average cost of each dress then the average cost of making dress will fall. When the marginal cost of producing a dress goes above the average cost of producing a dress then the average will start to rise.