Question

What explains the shape of the average and marginal cost curves? Is it linked to any production relationships?

Answer 1

The Marginal Cost curve is U shaped because initially when a firm increases its output, total costs, as well as variable costs, start to increase at a diminishing rate. At this stage, due to economies of scale and the Law of Diminishing Returns, Marginal Cost falls till it becomes minimum.

The relationship between average and marginal cost can be easily explained via a simple analogy. Rather than think about costs, think about grades on a series of exams.

Assume that your average grade in a course is 85. If you were to get a score of 80 on your next exam, this score would pull your average down, and your new average score would be something less than 85. Put another way, your average score would decrease.

If you scored 90 on that next exam, this grade would pull your average up, and your new average would be something greater than 85. Put another way, your average score would increase.

If you scored 85 on the exam, your average would not change.

Returning to the context of production costs, think of average cost for a particular production quantity as the current average grade and marginal cost at that quantity as the grade on the next exam.

One typically thinks of marginal cost at a given quantity as the incremental cost associated with the last unit produced, but marginal cost at a given quantity can also be interpreted as the incremental cost of the next unit. This distinction becomes irrelevant when calculating marginal cost using very small changes in quantity produced.

Following the grade analogy, average cost will be decreasing in quantity produced when marginal cost is less than average cost and increasing in quantity when marginal cost is greater than average cost. Average cost will be neither decreasing nor increasing when marginal cost at a given quantity is equal to average cost at that quantity.

The production processes of most businesses eventually result in diminishing marginal product of labor and diminishing marginal product of capital, which means that most businesses reach a point of production where each additional unit of labor or capital isn't as useful as the one that came before.

Once diminishing marginal products is reached, the marginal cost of producing each additional unit will be greater than the marginal cost of the previous unit. In other words, the marginal cost curve for most production processes will eventually slope upward, as shown here.