Theory of Production

In economics, production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also how
much of raw material ie., fixed capital and labor it employs and how much it will use. It
defines the relationships between the prices of the commodities and productive factors on one
hand and the quantities of these commodities and productive factors that are produced on the
other hand.
Concept
Production is a process of combining various inputs to produce an output for consumption. It
is the act of creating output in the form of a commodity or a service which contributes to the
utility of individuals. In other words, it is a process in which the inputs are converted into
outputs.
Function
The Production function signifies a technical relationship between the physical inputs and
physical outputs of the firm, for a given state of the technology.
Q = f a, b, c, . . . . . . z
Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the output
for a firm.

If labor L and capital K are only the input factors, the production function reduces to −
Q = fL, K

Production Function describes the technological relationship between inputs and outputs. It is
a
tool that analysis the qualitative input – output relationship and also represents the
technology of a firm or the economy as a whole.
Production Analysis
Production analysis basically is concerned with the analysis in which the resources such as
land, labor, and capital are employed to produce a firm’s final product. To produce these
goods the basic inputs are classified into two divisions −
Variable Inputs
Inputs those change or are variable in the short run or long run are variable inputs.
Fixed Inputs

1
Inputs that remain constant in the short term are fixed inputs.
Cost Function
Cost function is defined as the relationship between the cost of the product and the output.
Following is the formula for the same −

Long Run Cost

Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of
production is as low as possible.
Long run cost = Long run variable cost
In the long run, firms don’t have the liberty to reach equilibrium between supply and demand
by altering the levels of production. They can only expand or reduce the production capacity
as per the profits. In the long run, a firm can choose any amount of fixed costs it wants to
make short run decisions.
Law of Variable Proportions
The law of variable proportions has following three different phases −
Returns to a Factor Returns to a Scale Isoquants
In this section, we will learn more on each of them.
Returns to a Factor
Increasing Returns to a Factor
Increasing returns to a factor refers to the situation in which total output tends to increase at
an increasing rate when more of variable factor is mixed with the fixed factor of production.
In such a case, marginal product of the variable factor must be increasing. Inversely,
marginal price of production must be diminishing.
Constant Returns to a Factor
Constant returns to a factor refers to the stage when increasing the application of the
variable factor does not result in increasing the marginal product of the factor – rather,
marginal product of the factor tends to stabilize. Accordingly, total output increases only at a
constant rate.
Diminishing Returns to a Factor
Diminishing returns to a factor refers to a situation in which the total output tends to increase
at a diminishing rate when more of the variable factor is combined with the fixed factor of
production. In such a situation, marginal product of the variable must be diminishing.
Inversely the marginal cost of production must be increasing.
Returns to a Scale
If all inputs are changed simultaneously or proportionately, then the concept of returns to
scalehas to be used to understand the behavior of output. The behavior of output is studied

2
when all the factors of production are changed in the same direction and proportion. Returns
to scale are classified as follows −
Increasing returns to scale − If output increases more than proportionate to the increase
in all inputs.
Constant returns to scale − If all inputs are increased by some proportion, output will also
increase by the same proportion.

Decreasing returns to scale − If increase in output is less than proportionate to the

increase in all inputs.
For example − If all factors of production are doubled and output increases by more than
two times, then the situation is of increasing returns to scale. On the other hand, if output
does not double even after a 100 per cent increase in input factors, we have diminishing
returns to scale.
The general production function is Q = F L, K
Isoquants
Isoquants are a geometric representation of the production function. The same level of
output can be produced by various combinations of factor inputs. The locus of all possible
combinations is called the ‘Isoquants’.
Characteristics of Isoquants
An Isoquants slopes downward to the right. An Isoquants is convex to origin.
An Isoquants is smooth and continuous. Two Isoquants do not intersect.
Types of Isoquants
The production Isoquants may assume various shapes depending on the degree of
substitutability of factors.
Linear Isoquants
This type assumes perfect substitutability of factors of production. A given commodity may be
produced by using only capital or only labor or by an infinite combination of K and L.
Input-Output Isoquants
This assumes strict complementarily, that is zero substitutability of the factors of production.
There is only one method of production for any one commodity. The Isoquants takes the
shape of a right angle. This type of Isoquants is called “Leontief Isoquants”.
Kinked Isoquants
This assumes limited substitutability of K and L. Generally, there are few processes for
producing any one commodity. Substitutability of factors is possible only at the kinks. It is also
called “activity analysis-Isoquants” or “linear-programming Isoquants” because it is basically
used in linear programming.

3
Least Cost Combination of Inputs
A given level of output can be produced using many different combinations of two variable
inputs. In choosing between the two resources, the saving in the resource replaced must be
greater than the cost of resource added. The principle of least cost combination states that if
two input factors
Pricing and output decision
Pricing and output decisions focus on where to set the price for the product and how much quantity to
supply. A firm will choose to produce the quantity where marginal cost is equal to marginal revenue, or
where the marginal cost and marginal revenue curves intersect. However, pricing and output decisions
depend on the market structure. In a perfectly competitive market, a firm’s size is too small to impact the
prices in a market. In which case, the firm must be a price taker, so it must take the price given and decide
how much quantity to supply. In this type of market market, price is equal to the marginal cost of production.
In a monopoly, a monopolist can alter the prices since it is the only provider of a good and possesses the
market power. In this case, the monopolist must take the positive and negative effects of a price increase into
consideration. Hence, the monopoly makes his decision based on the elasticity of demand to determine the
profit maximizing price. 
If unit costs rise with output, price-taking firms will only produce more if price increases¹. Price-setting firms
will increase prices when they choose to expand output into the range where unit costs are rising¹. If a
reduction in output leads to a reduction in unit costs, they will decrease their prices¹. The actions of price-
taking and price-setting firms show the variables that must be factored into making pricing and output
decisions.
 Energy Efficiency Vs. Economic Efficiency
Engineers at a national research laboratory built a prototype automobile that could be driven 180 miles on a
single gallon of unleaded gasoline. They estimated that in mass production the car would cost $60,000 per
unit to build. The engineers argued that Congress should force U.S. automakers to build this energy-efficient
car.
Managerial Economics - Optimal Output and Pricing
Your local monopoly is considering selling several units of homogeneous product as a single package. A
typical consumer's inverse demand function is P = 200 - 4Q. Marginal cost is $120. a. Determine the optimal
number of units to put in a package. b. How much should the firm charge for this package?
Price Discrimination for Car Dealerships
Why is first-degree price discrimination seldom possible? Use the example of a car dealership to defend your
answer. You will also want to employ the three conditions necessary for price discrimination in your answer.
Economics: Pricing decisions.
Using anticipated sales data, recommend pricing of new tiers In response to increased requests for a la carte
pricing, a firm has decided to start a trial offering of smaller program tiers. As the first step of the trial, two
small program packages will be offered to those using our basic package. The first is a sports pack
Optimal Price and Quantity from Inverse Demand and Cost
Al Ain Dairy has reported that its annual sales on dairy products have increased by 20 percent, driven
primarily by a 40 percent increase in the demand for camel milk. The increase was largely attributed to a

4
news report describing the health benefits of camel milk. You are the manager of a rival dairy farm that sells
camels mil
Find out the dominant strategy of both the players (if any).
Please refer attachment for table. Bernie and Manny both sell DVD players. Now suppose they must
independently decide whether to charge high or low prices. To illustrate the problems encountered, consider
the following profit payoff matrix faced by Bernie and Manny in a one- shot, simultaneous-move game. The
first number in e
Production Economic Theory
Recently there has been a drive to increase the production of alternative fuels from corn. The argument used
by many is energy self-sufficiency. In light of the desire to reduce our use of foreign produced oil, many
have suggested we should subsidize this production and shift to alternative fuels. Is this a good or bad idea
from
The Pros and Cons of Raising Minimum Wages
Recently, the House of Representatives passed legislation to increase the minimum wage in the nation from
$5.15 to $7.50. What are the pros and cons of this proposal? Provide an analysis based on the demand and
supply of labor.
Firm's Supply Curve in a Perfect Competiton Market
A competitive firm producing a standardized product (Q) with the following marginal cost characteristic:
MC = $15 + 0.002Q. Find supply (output) of this firm when price = $9 and when price = $19.
Optimal Pricing
As a manager of a chain of movie theaters that are monopolies in their respective markets, you have noticed
much higher demand on weekends than during the week. You therefore conducted a study that has revealed
two different demand curves at your movie theaters. On weekends, the inverse demand function is P = 20 -
0.001Q; on wee
optimization of a contract length
Suppose the marginal benefit of writing a contract is $60, independent of its length. Find the optimal contract
length when the marginal cost of writing a contract of length L is: a. MC(L) = 20 + 3L MC(L) = 50 + 4L.
Instruction: Round your answers to 2 decimal places.
Calculating the Elasticity Coefficients
The demand curve for a product is given by QXd = 1,200 - 3PX - 0.1PZ where Pz = $300. a. What is the
own price elasticity of demand when Px = $140? Is demand elastic or inelastic at this price? What would
happen to the firm's revenue if it decided to charge a price below $140? Instruction: Round your response to
2 decimal
Perfect substitutes
Consumers often have difficulty distinguishing brand-name products from cheap knockoffs, especially when
making purchases over the web. This raises interesting questions about pricing and consumer behavior. a.
Suppose that customers can distinguish between brand name products and their knockoffs and do not view
brand name pro
Pricing, Profitability, and New Product Introduction

5
The Wall Street Journal recently reported that Proctor and Gamble is introducing a new low-price version of
Tide and raising the price of its high-end products. Answer the following questions about what the report
said and what you can derive from you understanding of pricing. a. "The idea is to 'keep the profit pool the
same
Economics
(c) From the DOL formula, you can see that a manufacturing plant with higher fixed costs and lower variable
costs will have a higher DOL relative to a plant with higher variable costs and lower fixed costs i.e. a capital
intensive production process will have a higher DOL than a labor intensive process which means that a
capital
Economic externality
Discuss methods of government intervention to correct externalities generally, including the adverse
consequences and why this example 'works' to improve efficiency.
The effect of tax cut on telecommunication price
You are an assistant to a senator who chairs an ad hoc committee on reforming taxes on telecommunication
services. Based on your research, AT&T has spent over $15 million on related paperwork and compliance
costs. Moreover, depending on the locale, telecom taxes can amount to as much as 25 percent of a
consumer's phone bill. The
Price Discrimination
Discuss the necessary conditions to make price discrimination work and the best practices to use price
discrimination to maximize profits while avoiding price wars. In your discussion make evident the
challenges of the strategy even in markets where it is possible.
Calculating Transfer Price
A firm has two semi-autonomous divisions: production and marketing. The production division
manufactures a product that is purchased and then resold by the marketing division. The marginal cost
functions for the production division and for the value added by the marketing division are defined below.
MCP = 2Q MCM = Q The d
Economics: Quantity and Demand
A firm manufactures a product that is sold on two different markets (A and B) that have the following
demand functions: QA = 100 -0.50PA QB = 60 -0.50PB The firm has the following marginal cost function:
MC = 20 + 0.80Q If the firm is engaging in price discrimination, what prices should be charged on each
market and
Finding the Optimal Output Price Combination
Consider an industry dominated by one firm that acts as a price leader. The industry also has a large number
of smaller price followers that can sell as much as they want at the price set by the dominant firm. The
demand curve for the output of all firms in the industry is: QT = - 42,500 + 70P The total cost curve for the
Pricing and Output Decisions: Supply and Demand
The Chilean Fruit Growers Association estimates the following market supply and demand curves for fruit:
QS = 125,000P QD = 200,000 - 50,000P Where Q is the daily output in pounds and P is the price per pound.
a) Determine the price and quantity that would result under competitive conditions. b) The Chilean Fruit
Economics: Demand and Supply at Kink
6
Looking for a detailed solution: The management of a firm believes that it faces a kinked demand curve. If it
sets price above the kink in demand, its rivals will not match the price, and it will be operating on the
demand curve: P1 = 35 -0.005Q If it sets price below the kink, management believes that it will be
Steps to finding the optimal output and price levels
Company A seeks help with its pricing decision. It has learned that the quantity demanded decreases by 3%
when price increases by 1%, demand is constant, and the average quantity and price are the denominators in
the percentage changes. Company A knows that marginal cost is constant as output changes but does not
know its value.
Fixed Cost & Effect of Output Increase/Decrease
The IT and finance departments of a firm report the values in the following table. The firm produces 20 units
of output. Average Total Cost=30 Average Variable Cost=20 Marginal Cost=27 Price=23 Marginal
Revenue=18 a. What is total fixed cost? b. What happens to profit if output increases slightly? i. Increase ii.
Decrease
Labor & Manufacturing Cost Considerations in Maximizing Profit
Company A seeks help making employment decisions. It employs labor and trucks by the hour and obtains
both in competitive markets. It currently employs 100 hours of labor and 20 hours of trucking services at $24
and $36 per hour, respectively. It sells its output in a competitive market at $10 per unit. Output is currently
500 p
Profit Questions
1. Company A wants help setting its price or prices. It knows that 20 men and 10 women are potential
customers and that each potential customer buys at most 1 unit of output. The 20 amounts men are willing to
pay are $50, $49, $47, $46, $44, $43, ..., $23, $22. The 10 amounts women are willing to pay are $48, $45,
$42, ..., $21.
Housing Bubble & Flood Insurance
(1) Due to the housing bubble, many houses are now selling for much less than their selling price just two or
three years ago. There is evidence that homeowners with virtually identical houses tend to ask more if they
paid more for the house. What fallacy are they making? (2) The U.S. government subsidizes flood insurance
be
Price Elasticity
You are the administrator for a medical practice. Assume all of your practice's patients are covered by
insurance. Insurance pays, on average, 80% of your fee for a physician visit for which your practice charge is
$100. The patient is responsible for the $100 fee but receives 80% back from the insurer. Currently, your
practice'
Long run insurance companies and profit
Is it true that in the long run insurance (Obamacare) companies can make profits at the expense of their
customers?
Locating the Firm in a Global Economy
Introduction

7
Locating a business in the right place is important because the cost of moving output and people across space is
significant. Some of the important location criteria are cost of shipping raw materials, close proximity to labour supply,
nearness to potential market etc.
Basic location principles
Locating in a linear market
If demand for a firm’s output does not vary with location, the problem of locating a plant or service center reduces to
one of cost minimization. Suppose that the letters A through I in the figure represent households located on a highway.
Such a distribution of customers is referred to as a linear market.

A B C D E F G H, I
0 1 2 3 4 5 6 7 8 9 10 11 12
Miles
Assume that each customer must be served once each month by delivering one truck load of output. (e.g. coal or fuel
oil for heating) to each home. The cost minimizing solution is to locate at the median point, where there are as many
customers on either side of the distribution center. Costs are minimized at this point because moving the firm on either
direction adds more distance to people in one side than it subtracts from people on the other. The median location is at
the 5 mile mark, where there are four customers on either side of the firm. The total mileage required to serve all
customers is 70 miles computed as a sum of a 10 mile round trip to A plus an 8 mile round trip to B and so on.
Firm location: One market and one raw materials source
In this case of location decision the firm obtains raw materials at one site (M), processes them, and distributes to
customers in a city (C). As shown in the figure, the raw materials and market sites, M and C, respectively, are T miles
apart.

Assume that production cost, the price of output, and the quantity sold are the same regardless of where the firm
locates the plant. The only variables are the total costs of transporting raw materials and output. Let Sm be the cost per
mile of shipping enough raw materials to make one unit of output and So be the cost per mile of shipping one unit of
output. The cost function for shipping raw materials is Smt, which determines the cost of shipping one unit of raw
material from M to any location t miles to the right of M. If the plant is located at the raw materials site, then t = 0 and
the cost of shipping materials is zero. The output shipping cost function is given by So (T –t), which defines the cost of
shipping one unit of final product from any location (T-t) miles to the left of C to that city. If the plant is located at C,
the value of (T-t) is zero and the shipping costs for output are zero.

At any intermediate point between M and C, there are shipping costs for both raw materials and output. The sum of
these two costs is defined as total transportation costs. As price and other production costs are assumed to be constant
at all locations, the problem reduces to choosing that site with the lowest total transportation costs. In the figure, the
per-mile cost of shipping one unit of raw materials is assumed to be greater than the cost of shipping one unit of

8
output. Thus total transportation costs are minimized at the raw material site M. In contrast, had transportation cost per
mile for raw material been lower than for one unit of output, the lower total transportation costs would be achieved by
locating at C.

The transport cost (TC) of locating the plant at any site t miles to the right of M is the sum of shipping costs for raw
materials and output, that is, TC = Sm t + So (T –t). As the objective of the plant location decision is to minimize TC,
it should be clear that if Sm > So, the value of t should be made as small as possible. This is accomplished by locating
the plant at M , where t = 0,as shown in the above figure. Alternatively if, Sm < So, total costs are minimized by
making t as large as possible i.e. (t =T) and locating the plant at C.
Market area determination
The market area for any one seller will depend on relative production and transportation costs. The market areas for
two competing firms will be determined under different assumptions relative to those costs.
Market area: Equal production and transportation costs
Suppose that two competing firms, A and B, have located production facilities in a region and that both have the same
production and transportation costs. The price at the plant is set equal to production costs, and transport costs are paid
by the consumer. Consumers will buy from that plant for which the delivered price (i.e. price at plant plus transport
cost) is lower. The figure 1(a) below shows delivered price functions for firms A and B located at points A1 and B1
along the distance or horizontal axis. Production cost is OP at both plants. Any buyer located at point A1 or B1 pays
OP, but more distant buyers must pay OP plus the transportation cost per unit of output.

Because consumers seek the lowest price, all those located to the left of point D will buy from A and those to the right
of D will buy from B. Looking down on this two- dimensional market area, as shown in figure 1(b), it is seen that the
line FG separates the two markets. Along this market boundary, the delivered price is the same for both plants. To the
right of this line, the price is lower for B and to the left, it is lower for A.

Market area: Unequal production costs- Equal transportation costs

Suppose that firm B’s production cost per unit increases, while the costs at firm A remain the same. The following
figure 2(a) depicts the market areas for the two firms where A is able to produce at a lower cost than is B. As a result,
the price at the plant is lower for A than for B. Per mile transport costs are assumed to remain equal for both firms.
Thus, the slope of the delivered price functions is the same, but the cost functions for firm B is higher by the amount of
the production cost differential between the two firms. The change results in A’s market area increasing significantly.
That is, now some customers who are geographically closer to B will buy from A because the lower production cost
has more than offset the greater transportation cost. Also, the boundary between the markets, the curve F1G1 in figure
2(b) is now non linear.

9
Market area: Unequal production and transportation costs
Suppose that both production and transportation costs are lower for A than for B. Transportation costs may be lower
for A because it has developed access to lower cost barge and/or rail service, whereas B may be restricted to rising
higher cost truck service. Alternatively, B may simply have higher costs due to obsolete equipment and/or poor
transportation management. The determination of the market area for each firm is depicted in figure3(a) below. B’s
market area is restricted to the area between D11 and E1. Even though customers to the right of E1 are closer to B1
than to A1, the delivered price from A actually is lower. A’s lower production and transport costs have reduced B’s
market area to a small circular area. The two dimensional perspective of this market area for firm B is the smaller
circular area B*B*. Firm A captures the remainder of the market areas.

It is possible that further reduction in A’s production and/or transportation costs could occur to the point that the
delivered price function for firm A would intersect that for firm B below the level of B’s production cost OP1. In that
event, firm A would capture the entire market area and B would be out of business.

Factors affecting industrial location

The locational factors considered by managers to select a location are classified as primary and secondary.
I. Primary location factors
1. Labour
The availability, cost and productivity of labour are very important location determinants. A new facility is not built in
a location unless management is convinced there is an adequate supply of workers available who have the training and
experience needed for planned operation.
2. Energy resources
Some manufacturing processes use large quantities of energy per dollar of final output. For example, the processing of
bauxite into aluminum requires large quantities of electricity. Aluminum manufacturers have tended to locate in areas
that offered low cost electric power.
3. Transportation
Transportation cost is also an important factor in industrial location decisions. The rapid growth of cities has offered
good access to transport modes. For example, the manufacturing activity that has developed largely on smaller
communities and in suburban areas of large cities has depended largely on truck transport and the development of the
interstate highway system.

4. Proximity to markets for output

It is advantageous for firms to be able to serve their customers quickly and at low cost. The cost of transportation can
be minimized, both people to work and products to consumers. These forces combine to ensure that many firms will
locate in population centers.

10
5. Government regulations
Federal, state and local governments are assuming a more aggressive role in determining where industry can locate.
Many local governments have used zoning laws to regulate the location of business within the city. More recently, air
and water quality rules imposed by federal and state governments have been important in determining where polluting
industries can locate.
6. Raw materials availability
Some businesses depend on materials of various types, such as unprocessed raw materials, for use in manufacturing
and finished goods for inventory in wholesale and retail establishments.
II. Secondary location factors
1. Physical environment
The climate, scenery, and environmental quality of an area may affect a location decision, especially if the other more
fundamental characteristics are approximately the same as in the other locations being considered. The competitive
pressures of the market place would drive out firms whose important decisions are based on personal preference rather
than economic considerations.
Fixed costs (FC) - costs that do not change as production is increased or decreased. They have to be paid in advance
of production. They exist even if output is zero.
Variable costs (VC) - costs that vary with output.
Total, average and marginal cost
Total costs (TC) - the sum of fixed costs and variable costs at a particular level of output. So TC = TFC + TVC.
Marginal costs (MC) - the cost of one more unit of output. In other words the increase in total cost from producing
one more unit of output.
Average costs (AC) - total costs divided by the level of output. There are three aspects of average cost: average total
cost (ATC) which is total cost divided by the level of output, average fixed cost (AFC) which is total fixed cost
divided by the level of output and average variable cost (AVC) which is total variable cost divided by the level of
output.
These costs all relate to operations at a point in time, but they can all vary with time.
Fixed costs
These costs are those that remain unchanged as the output level of the firm changes. It does not matter what level of
output the firm produces (even zero output makes no difference), any cost which is a fixed cost will remain the same.
Common examples of fixed costs are as follows:
Examples of fixed costs
Rent
Interest on loans
Insurance
Depreciation
Fixed costs can be represented graphically and this would appear as follows:

11
Figure 1 Total fixed costs
Variable costs
Any cost which varies directly with the level of output would be classified as a variable cost. Varying directly means
that the total variable cost will be dependent on the level of output. Common examples of variable costs are as follows:
Example of variable costs
Direct labour
Raw materials and components
Packaging costs
Heating and lighting
Variable costs can be represented on a graph and this would appear as follows:

Figure 2 Total variable cost

We could also classify costs as semi-variable costs. Have a think about what these might be and then follow the link
below.
Semi-variable costs
Calculating costs
You also need to be able to calculate a firm's costs from given data, be able to draw cost curves and then interpret what
they mean. We come to that skill later.
You will also need to identify and explain short-run and long-run cost curves. Look carefully at the following
examples.

12
Figure 3 Short-run average cost curve

Figure 4 Long-run average cost curve

In the short-run, at least one factor input is fixed. In the long-run all inputs are variable. This means that short-run
curves are models of what is happening. Long-run curves are planning data. A firm cannot operate with all inputs
variable. Having decided what it wants from an examination of the long-run curves, the firm makes a decision to fix a
factor, usually capital, and this gives rise to a new short-run situation.
Now, the calculations and the drawing!
You could be presented with data in the form of a table, like the one below

Output 0 1 2 3 4 5 6 7 8 9 10
(units

Total 100 110 125 145 170 200 235 275 320 370 425
cost ($k)

Plot this with output on the horizontal axis and total cost on the vertical axis and look at it.
There is also a static version of this graph available.
What do you know now?
The firm has fixed costs of $100,000, the cost of 'output zero'.
The total variable cost is increasing with increasing output

13
Now, some more sums. Work out the average cost (TC / output), the total variable cost (TC - FC), the variable
cost (TVC / output), the average fixed cost (FC / Output) and the marginal cost (TC (Qx) - TC (Qx-1)).
Once you have had a go at calculating all these, follow the answer link below to compare how you got on.
Answer - cost calculations
Now plot this data on two separate graphs as follows, and see what it shows.
Graph 1 - Total cost, total variable costs and total fixed costs
Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost
You should get the following:
Graph 1 Total cost, total variable costs and total fixed costs
There is also a static version of this graph available.
Graph 2 - Marginal cost, average cost, average fixed cost and average variable cost
There is also a static version of this graph available.
Average cost (AC) falls initially, then turns and starts to rise.
AFC + AVC = AC.
MC follows the same pattern, but at a more exaggerated rate.
Marginal cost and average cost cross at the minimum average cost.
See Figure 6 below for the standard representation of these curves.
Why do average and marginal cost cross at the minimum point of average cost?
Well think of this in terms of cricket scores. Your last innings is your 'marginal' innings, whereas your batting average
is your 'average'. Say your average is 50 and in your next innings you get 20 runs. What happens to your average? It
will fall. However, if in your next innings you get 80 runs. In this case your average will rise.
So, if the marginal is below the average, the average will fall and if the marginal is above the average, the average will
rise.
There are many questions for you to work on in the questions section (click on the questions - module 2 link in the left
hand navigation bar). It may also be worth having a look at the Diggin' diagrams sections (accessible from the course
homepage) to check how well you understand your diagrams.
Interactive spreadsheet
To see how changes in cost affect the cost curves, why not have a look at our interactive spreadsheet. On this, you can
make changes in the values of costs and instantly see the effect on the diagram of cost curves. Follow the link below to
view the spreadsheet.

14