Q.Define the Cost of Production. Explain the relationship between Average Cost and Marginal Cost.
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Start your 14-day free trial to unlock the full solution →Cost of production is total spending on all factors; MC pulls AC down when MC<AC, pushes it up when MC>AC, and cuts AC at its minimum.
Cost of production refers to the total expenditure incurred by a firm on the various factors of production and inputs — wages to labour, rent for land, interest on capital, payment for raw materials, fuel, and normal profit to the entrepreneur — in order to produce a given quantity of output. It includes both explicit costs (actual money payments) and implicit costs (imputed cost of self-owned factors).
Average Cost (AC) is total cost per unit of output (AC = TC/Q), and Marginal Cost (MC) is the addition to total cost from producing one more unit. Both AC and MC curves are U-shaped because of the law of variable proportions.
Relationship between AC and MC:
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When MC is less than AC, AC is falling. Because the additional unit costs less than the existing average, it pulls the average down.
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When MC is greater than AC, AC is rising. The additional unit costs more than the existing average, so it pulls the average up.
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When MC is equal to AC, AC is at its minimum point. Therefore the MC curve cuts (intersects) the AC curve from below exactly at the lowest point of the AC curve.
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