No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 167 You should notice that the marginal cost curve intersects both the average variable cost and average total cost curves at their minimum value. This is always the case, and reflects the definition of marginal and average quantities. Let’s take a baseball case, for example. If Mike Trout has a batting average of .320, and he hits a hot streak, with his “marginal” average (say the next series) up to .600, what will happen to his overall average? It will go up, reflecting his better performance; perhaps to .322 (depending on how many at-bats he already has that season). We can see the same thing in Figure 7.8 ; when the marginal value is greater than the average value, the average value will begin to rise. Similarly, if Mike Trout goes into a slump and is only batting .150 during a road trip, his overall batting average will drop. We also see this effect in Figure 7.8 ; when marginal costs are below average costs, average costs are decreasing. Students can see the same thing in their grade point average (GPA). If your overall GPA is 3.5 and you have a 4.0 semester, your cumulative GPA will rise. If instead you “party” all semester and barely pull out a 2.0, your cumulative GPA will fall! Why would an entrepreneur care about average vs. marginal costs? Well, for tax purposes, he or she will need to calculate profits based on total profits and total costs. These total costs are applied against the total quantities produced, giving an average (per unit) cost. But the marginal cost is always the one that must guide his or her decision whether to expand or decrease production. Do not immediately think, however, that a profit maximizing entrepreneur will expand output if marginal costs are decreasing and decrease production if marginal costs are rising. We’ll see later in this chapter that an entrepreneur will want to expand production as long as marginal costs are lower than marginal revenues. RELATIONSHIP BETWEEN COST AND PRODUCT CURVES If you look at our product and cost curves carefully, you’ll see the same explanation for the changing shapes in the curves—indeed, product and cost curves are closely related. If you compare Figure 7.9 to Figure 7.5 , you’ll see that as production efficiency increases due to division of labor and gains from specialization, production rises at an increasing rate, and costs are decreasing. As diminishing returns ultimately set in, we see production efficiency decrease and costs rise. This gives us clues as to how to maximize profit: increasing production efficiency both increases output and decreases costs. This explains entrepreneur’s relentless pursuit of efficiency—those companies that don’t become more efficient will go the way of the dodo bird. Investment capital tends to flee companies that do not innovate or become more efficient. Figure 7.9, Product Curves and Cost Relationship. Notice how gains from specialization and diminishing returns drive the cost curves: as production efficiency is increasing via the gains from specialization, costs are decreasing. When production efficiency is decreasing due to diminishing returns, costs are rising. Compare this to the shape of our product curve in Figure 7.5. Output (Q) Production Drives Costs Costs ($) MC ATC Diminishing Returns Gains from Specialization