7.8 : Relationship between Average and Marginal Costs

Marginal Cost (MC) is a variable cost that refers to the additional expenses incurred by the firm when producing one more unit of a good or service. The Average Variable Cost (AVC) represents the total variable costs per unit produced and the Average Total Cost (ATC) represents the total cost per unit produced. As production increases, the relationship between MC and AVC, and between MC and ATC, are the same. The following description will refer to both of these cost terms simply as Average Cost (AC).

The relationship between average cost (AC) and marginal cost (MC) is pivotal in understanding production efficiency. Typically, when MC is less than AC, AC falls as production increases. When MC is greater than AC, AC rises as production increases. Why does this relationship exist?

When MC is below AC, producing an additional unit contributes less to the total cost of production than the existing average, leading to a lower AC. Conversely, when MC is above AC, producing an additional unit contributes more to the total cost of production than the existing average, causing AC to rise. The reason behind this is the law of diminishing marginal returns.

Understanding the relationship between AC and MC enables firms to optimize production levels, minimize costs, and make informed decisions regarding production levels and cost management strategies.