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Average cost

Marginal cost is a term in economics. It concerns the extra expense involved for producing more units of given product. In general, marginal cost goes down as more items are produced - a fact often encompassed in the phrase "economies of scale."

To understand why, imagine you are the manager of a factory that produces 'widgets'. To produce one widget, you must pay for the machinery necessary. Then you will need workers and material to build with. After that, producing more widgets (up to a point) is a matter of hiring more work force and buying material. While the first widget might have cost thousands of dollars (the machinery + the initial employees and materials), the cost of the second and third widgets would only be equal to that of the added workers and materials.

The cost of each added widget is its marginal cost.

But this is about Average cost.

The average cost means just what it says, the average cost. The cost of making all of the widgets divided by the number of widgets made. If one widget costs $10,000 for the machinery plus $600 for the workforce and material, and the second widget only costs $50 (for the material) but doesn't require extra machinery or workers, the average cost for those widgets would be $5,325, the total cost ($10,650) divided by the number of widgets (2).

Average cost is often greater than Marginal cost. Once you pay for the machinery and workers, it doesn't cost much to make one more widget. While the average cost described above is thousands of dollars, the marginal cost in the same situation is only $50 (for the supplies). When you make more widgets, the average price decreases. If you made 10 widgets, and each widget after the first costs $50, the average price would be 1,110, the total cost ($11,100) divided by the number of widgets (10). This is called economies of scale: the bigger your operation is, the cheaper you can make one more widget.

Last updated: 08-31-2005 09:27:41
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