AEC 506 INTRODUCTION TO LIVESTOCK ECONOMICS AND MARKETING LECTURE 5 MARGINAL COST AND RETURN AND LAW OF DIMNISHING MARGINAL RETURN

Acnowledgement Ms. Vashnika Narayan

WHAT IS MARGINAL COST OF PRODUCTION The marginal cost of production is the change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale.

The increase or decrease in the total cost of a production run for making one additional unit of an item. It is computed in situations where the breakeven point has been reached: the fixed costs have already been absorbed by the already produced items and only the direct (variable) costs have to be accounted for. Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion of fixed costs (such as administration overheads and selling expenses). In companies where average costs are fairly constant, marginal cost is usually equal to average cost.

You can use marginal costs for production decisions You can use marginal costs for production decisions. If the price you charge for a product is greater than the marginal cost, then revenue will be greater than the added cost and it makes sense to continue production. However, if the price charged is less than the marginal cost, then you will lose money and production should not expand. Formula for calculating marginal cost: Marginal Cost (MC) = ΔTC ΔQ Where: Δ – Change TC- Total Cost Q - Quantity

Long-Run versus Short-Run Short run: a period of time during which one or more of a firm’s inputs cannot be changed. Long run: a period of time during which all inputs can be changed. For example, consider the case of Bob’s Bakery. Bob’s uses two inputs to make loaves of bread: labor (bakers) and capital (ovens). (This is obviously a simplification, because the bakery uses other inputs such as flour and floor space. But we will pretend there are just two inputs to make the example easier to understand.) Bakers can be hired or fired on very short notice. But new ovens take 3 months to install. Thus, the short run for Bob’s Bakery is any period less than 3 months, while the long run is any period longer than 3 months.

The concepts of long run and short run are closely related to the concepts of fixed inputs and variable inputs. Fixed input: an input whose quantity remains constant during the time period. Variable input: an input whose quantity can be altered during the time period.

Fixed Cost Fixed cost (FC): the cost of all fixed inputs in a production process. Another way of saying this: production costs that do not change with the quantity of output produced. Since fixed inputs cannot be changed in the short run, fixed cost cannot be changed either. That means fixed cost is constant, no matter what quantity the firm chooses to produce in the short run. Variable cost (VC): the cost of all variable inputs in a production process or the production costs that change with the quantity of output produced. Variable cost, on the other hand, does depend on the quantity the firm produces. Variable cost rises when quantity rises, and it falls when quantity falls.

Total Cost – when the fixed cost and variable cost is added together Total Cost – when the fixed cost and variable cost is added together. Formula: TC = FC + VC E.g. Calculate the total Cost for the following Quantity Per Day Fixed Cost Variable Cost Total Cost 100 75 220 295 150 350 425 300 460 535 370 500 575

Average Cost or Average Total Cost Average cost (AC), also known as average total cost (ATC), is the average cost per unit of output. To find it, divide the total cost (TC) by the quantity the firm is producing (Q). Average cost (AC) or average total cost (ATC): the per-unit cost of output. ATC = TC/Q Since we already know that TC has two components, fixed cost and variable cost, that means ATC has two components as well: average fixed cost (AFC) and average variable cost (AVC). The AFC is the fixed cost per unit of output, and AVC is the variable cost per unit of output. ATC = AFC + AVC AFC = FC/Q AVC = VC/Q

Quantity Per Day Fixed Cost Variable Cost Total Cost Average Total Cost (TC/Q) Average Fixed Cost (FC/Q) Average Variable Cost (VC/Q) Marginal Cost (ΔTC/ΔQ) 100 75 220 295 2.95 0.75 2.2 - 150 350 425 2.83 0.50 2.33 2.6 300 460 535 1.78 0.25 1.53 0.73 370 500 575 1.55 0.20 1.35 0.57

LAW OF DIMINISHING MARGINAL RETURNS The law of diminishing marginal returns means that the productivity of a variable input declines as more is used in short-run production, holding one or more inputs fixed. This law has a direct bearing on market supply, the supply price, and the law of supply. If the productivity of a variable input declines, then more is needed to produce a given quantity of output, which means the cost of production increases, and a higher supply price is needed.

VARIABLE INPUT An input whose quantity can be changed in the time period under consideration. This should be immediately compared and contrasted with fixed input. The most common example of a variable input is labor. A variable input provides the extra inputs that a firm needs to expand short-run production. In contrast, a fixed input, like capital, provides the capacity constraint in production. As larger quantities of a variable input, like labor, are added to a fixed input like capital, the variable input becomes less productive.

SHORT-RUN PRODUCTION An analysis of the production decision made by a firm in the short run, with the ultimate goal of explaining the law of supply. The central feature of this short-run analysis is the law of diminishing marginal returns, which results in the short run when larger amounts of a variable input, like labor, are added to a fixed input, like capital. Further steps include the cost of short-run production, especially marginal cost, and the market structure in which a firm operates, such as perfect competition or monopoly.

Principle of Diminishing Returns Values need to be provided to understand the law of diminishing economic returns. The additional cost of each unit of input is called marginal cost. The additional return resulting from each unit of input is called marginal returns. Net returns will be highest when marginal cost is equal to marginal return.

Marginal Product Marginal product = change in total product associated with each additional input of a variable resource.

(extra output added by each extra unit of NPK) Calculate the marginal product for the following: Units of NPK (Kg) Total Output (Kg) Marginal Product (extra output added by each extra unit of NPK) 10 - 1 20 2 32 12 3 45 13 4 60 15 5 74 14 6 87 7 99 8 110 11 9 120 125

Questions 1. Calculate the following types of cost for the given exercise: Total Cost, Average total cost, Average fixed cost, Average Variable Cost and marginal cost for the following. Quantity Fixed Cost Variable Cost 170 50 182 220 245 265 250 280 296 315 365 325 379 395 405 412

2. Calculate the marginal product for the following Units of Labor Input Total Output of Maize 1 2000 2 2300 3 3000 4 3500 5 3800 6 3950