Today's exercise will be to work short-run cost theory on a diagram, specificallly looking at marginal cost and diminishing returns.
Question:
Explain what is happening on the diagram:
1) Moving from point A to point B
2) Moving from point B to point C
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ANSWER:
From point A to point B on the diagram, you will notice that the marginal cost is decreasing as the output rises. This means that the cost of producing an extra unit of output for the firm is less than the previous unit of output.
The reason for the above is because the firm begins to employ extra variable factor inputs (labour, for example) and is getting more additional output back in proportion. Therefore, the cost per unit of each extra unit of output is decreasing.
From point B to point C on the diagram, you will notice that marginal costs are increasing as output is rising. This means the cost of producing an extra unit of output for the firm is greater than the cost of the previous unit of output.
The reason for this is because at point B the firm experiences diminishing returns. From this point onwards, when the firm increases its variable factor inputs, the firm gets back less additional output than before. For example, hiring an extra worker may bring back 5 extra units of output, whereas before point B, hiring an extra worker may have returned an additional 8 units of output. The effect this has on the cost per additional unit will be an increase, hence why MC is rising after point B.
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