Concepts That Help to Provide Understanding of How the Cost Curves Are Derived
Concept |
Explanation |
Short-run
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That period of time in which at least one factor of production is fixed. E.g. it is difficult to change machinery or the number of factories in the short run, but that can be achieved in the long run. The variable factor that is usually added to production is labour as it is easy to hire new workers
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Long-run |
That period of time in which all of the factors of productions are variable. This is also called the planning stage as firms can plan for increased capacity and production
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Marginal product of labour (MP)
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The change in output that results from adding an additional unit of labour |
Law of diminishing marginal productivity
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In the short run, as more of a variable factor (e.g. labour) is added to fixed factors (e.g. capital), there will initially be an increase in productivity. However, a point will be reached where adding additional units begins to decrease productivity due to the relationship between labour and capital
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- In the short-run, the shapes of the cost curves (AC, AVC & MC) are determined by the law of diminishing marginal productivity
In the short run, marginal product (MP) increases with the addition of three workers before diminishing returns for each additional worker begin
Diagram Analysis
- A small food van selling burgers (product) at a music festival increases productivity up to the addition of a third worker
- After that, workers get in each other's way & there is not enough grill space (capital) & MP no longer increases
- If more workers are hired, then the MP of each additional worker begins to fall
- Adding additional workers up to the 7th worker will keep increasing the total product
- With the hiring of the 7th worker, the MP turns negative which will decrease the total product
Connection Between Diminishing Marginal Returns & The Cost Curves
- As the marginal product increases, marginal costs decrease
- There is an inverse relationship
- Increasing returns = decreasing costs
- Decreasing returns = increasing costs
Diagram Analysis
- The distance between the AVC & AC = the AFC
- AVC converges towards AC as the AFC continuously decreases with an increase in output
- AVC decreases as additional workers are added & each worker produces additional product
- Marginal costs (MC) decrease initially as additional workers are added & the marginal product is increasing
- Diminishing returns begin when the MC starts to increase
- MC will cross the AVC and AC curves at their lowest point
- As long as the cost of producing the next unit (MC) is lower than the average, it will pull down the average
- When the cost of producing the next unit (MC) is higher than the average, it will pull up the average