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Case Study 1 Marginal Cost Pricing

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  • So perhaps you can see how this lecture provides you

    with a lot of valuable nuts and bolts for future use.

    [SOUND].

    Now let's complete our short run cost analysis table

    by introducing the final three columns in our table.

    For average fixed cost, average variable cost and average total cost.

    These columns are simply derived by calculating averages using

    columns one through four and the formulas in the table.

    Using the formulas, try filling in the question marks now.

    The interesting thing about these three

    [SOUND]

    columns is the graph we can draw from them and our now old friend, marginal cost.

    The AFC curve approaches zero because as a firm's output increases, it spreads its

    fixed costs over a larger number of units. So average fixed costs must fall.

    For the same reason the AVC curve

    must approach the ATC curve as output increases.

    These are important insights in business, because the name of the

    game is often to spread your fixed costs over as many units

    as possible. Now, here's a trickier question.

    We know why the ATC, AVC, and MC curves slope first down and then up.

    It's the law of diminishing returns, remember?

    But why the does the MC curve intersect

    both the AVC and AC curves at their minimums?

    Take a minute to try and write down your answer.

    The answer lies in these formulas, if MC is greater

    than ATC, then the ATC must be rising and vise versa.

    Think of it this way.

    If the production of an additional unit has

    a marginal cost greater than the average cost.

    Then production of that unit must drive the

    [SOUND]

    average up, and conversely. Thus, it must be that only when MC equals

    ATC that the ATC is at its lowest point. This is a critical relationship.

    It means that a firm searching for the lowest average cost of production

    should look for the level of output at which marginal cost equals average cost.

    Now here's the punchline.

    [SOUND]

    When marginal cost is coupled with the concept of

    marginal revenue, that we will introduce in the next

    lecture The firm is able to determine if it

    is profitable to expand or contract its production level.

    In fact, the analysis in the next several

    lectures centers on these types of marginal calculations.

    That's why learning these nuts and bolts concepts now is so important.

    [SOUND]

    And this completes our exploration of short run cost analysis.

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