Wonderful World of Economics

How Firms Operate Lectures

Lectures should have covered the section on the shape of the AVC and why it is U-shaped. Upon feedback, there is confusion as to when diminishing marginal returns set in.

Do remember that it all stems from the marginal cost curve. When there is increasing returns to variable factor (each additional labour adds more to TP than the previous unit of labour), it costs less for the firm to produce an additional unit of output. Hence, MC (the cost incurred in producing an additional unit of output) decreases. As MC falls, AVC will fall. This is going back to the relationship between marginal cost and average variable cost.

However, as diminishing marginal returns to labour set in, due to overcrowding of the fixed factor, costs incurred in producing an additional unit of output will increase. More labour is needed just to produce additional unit of output. Thus, MC will start to increase. Note: diminishing marginal returns set in at minimum MC. Going back to the relationship between MC and AVC, even though there is an increase in MC, if the value of MC is less than AVC, AVC will continue to fall. Howver, once MC is above AVC, AVC will start to increase. Thus, explains why the AVC is U-shaped and the relationship to the law of diminishing marginal returns.

Key Points to Note:
1. the point in which diminishing marginal returns set in.
2. the relationship between MC and AVC.
3. using the law of diminishing marginal returns to explain the shape of the curves.

You will understand the reasons the need to know all these technical stuff soon enough! In the meantime, go revise your notes.

posted by Fio @ 7:50 AM