The Power Of Microeconomics

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The PowerOf Microeconomics
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Supply And Production Theory
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Lesson 4 Colander McConnell Samuelson
Schiller Brue Nordhaus
Complete Textbook (includes both Micro-and
Macroeconomics) Microeconomics Text Only
23,24 22 6,7 21
9,10 9 6,7 6
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Nuts And Bolts

• In fact, to at least some of you, this lesson is
  going to seem like an unending stream of dry
  definitions destined to be forgotten sixteen
  nanoseconds after youve finished your final
  exam.

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Two Things

• First, the definitions and concepts we will learn
  in this lesson are indeed the nuts and bolts that
  we will need to hold together a great many of the
  real world, microeconomic applications that will
  soon follow.
• Second, this material can be made relevant to
  your own personal and professional experiences.

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Back To The Business Future

• Youre a refugee from the new millenium, circa
  2000 AD, and you find yourself smack dab in the
  middle of 1972 shortly before the OPEC oil cartel
  slapped an embargo on the American economy.

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Your Possessions

• The design and engineering blueprints of a highly
  energy efficient automobile blueprints that
  your mad scientist buddy stuffed in your hands
  just before he accidentally catapulted you back
  to one of the worst decades in American economic
  history.

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What Do You Do?

• Lets assume that the only way you can save the
  planet from a rapacious foreign cartel and also
  get back home to your family and friends -- is to
  make a few million bucks producing these energy
  efficient cars.
• How do you do it?

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The Production Function

• The first thing you have to settle upon is your
  recipe for producing the car. In economics, we
  call this the production function, and
  algebraically, it looks like this
• Q F(K,L,R)

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Q F(K,L,R)

• Q is the quantity of cars you want to produce.
• K is the capital or plant and equipment that you
  will need for the production.
• L is the number of employees or quantity of
  labor.
• R is a catch-all term for other things like raw
  materials and energy.
• F is the state of the current technology.

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In Technical Terms...

• The production function specifies the maximum
  output that can be produced with a given quantity
  of inputs for a given state of engineering and
  technical knowledge.

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Two Questions

• In order to make your millions, what combination
  of inputs are you going to choose and what will
  be the size of your automobile plant?
• Those are two questions we will be able to answer
  later.
• Before we do that, lets make a further
  distinction between the short run and the long
  run.

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The Short Run

• Suppose the factory for your energy efficient
  auto is producing 10,000 cars a year.
• Further suppose the OPEC cartel slaps an embargo
  on the U.S. and quadruples the price of oil
  just as it did in 1973 and 1974.

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At This Point

• Demand starts to increase dramatically for your
  cars as consumers seek to substitute your Gas
  Miser for their gas guzzlers.
• What do you do?

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In The Short Run

• You add two more shifts, hire more workers and
  use more energy and raw materials as you try to
  run your plant around the clock to meet increased
  demand.
• This is your only option because it would take
  over a year to build a new factory.

• The short run The period in which firms can
  adjust production only by changing variable
  factors such as materials and labor but cannot
  change fixed factors such as capital.

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The Long Run

• In contrast, the long run is a period
  sufficiently long enough so that all factors in
  the production function, including capital, can
  be adjusted.
• In this case, it is the time it would take for
  you to expand your existing factory or build a
  new one.

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• This distinction is important because each period
  has its own kind of cost analysis.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156
4.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 ? 157 207 2.78
8.72 11.50 21 ? 182 232 2.38
8.67 11.05 23 ? 200 250 2.17
8.70 10.87 10 24 ? 210 260 2.08
8.75 10.83 28 ? 250 300 1.79
8.93 10.72 15 29 ? 265 315 1.72
9.14 10.86 32 ? 350 400 1.56 10.94 12.50

• The first column is the quantity of cars your
  factory can produce in thousands and the second
  column simply represents your firms fixed
  costs.
• These fixed costs are sometimes called overhead
  or sunk costs and fixed costs are those costs
  that do not change with the level of output.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 ? 157 207 2.78
8.72 11.50 21 ? 182 232 2.38
8.67 11.05 23 ? 200 250 2.17
8.70 10.87 10 24 ? 210 260 2.08
8.75 10.83 28 ? 250 300 1.79
8.93 10.72 15 29 ? 265 315 1.72
9.14 10.86 32 ? 350 400 1.56 10.94 12.50

• Examples of such fixed costs include rent,
  interest on the bonds you issued to get money to
  build your factory, insurance premiums, the
  salaries of top management, and so on.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106
156 4.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 ? 2.17
8.70 10.87 10 24 50 210 ? 2.08
8.75 10.83 28 50 250 ? 1.79
8.93 10.72 15 29 50 265 ? 1.72
9.14 10.86 32 50 350 ? 1.56 10.94 12.50

• Variable costs are simply those costs that change
  with the level of output.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC

4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106
156 4.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 ? 2.17
8.70 10.87 10 24 50 210 ? 2.08
8.75 10.83 28 50 250 ? 1.79
8.93 10.72 15 29 50 265 ? 1.72
9.14 10.86 32 50 350 ? 1.56 10.94 12.50

• Raw materials, fuel, and wages are all variable
  costs.
• Note that total cost is simply variable costs
  plus fixed costs.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 ? 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 ? 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 ? 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50

• Marginal utility is the additional utility a
  consumer gets from a one-unit increase in
  consumption.
• How would you define marginal cost?

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 ? 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 ? 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 ? 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50

• Marginal cost is simply the additional cost
  incurred in producing one extra unit of output.

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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 ? 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 ? 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 ? 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156 4
.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
fall
rise
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The Law of Diminishing Returns

• In production theory, we have to first remember
  that in the short run, capital is fixed but
  factors like labor are variable.
• In such a situation, adding more workers means
  that each additional unit of labor has less
  capital to work with.
• At some point then, the extra or marginal product
  of each additional worker must begin to decrease.
  
• Thats the law of diminishing returns.

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The Marginal And Total Products

• By the way, knowing what you now know about the
  concepts of marginal utility and marginal cost,
  how would you define marginal product?

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The Marginal Product

• The marginal product of an input such as labor is
  the extra output added by one extra unit of the
  input, holding other things such as capital
  constant.

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The MP Can't Keep Rising

• For example, in your car factory, as you add more
  and more workers, the assembly line starts to get
  too crowded and workers have to wait in line to
  use the machines.
• Thus, at some point the total product or total
  output keeps increasing but begins to do so at a
  decreasing rate.

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(1) (2) (3) (4) Units Total Marginal Avera
ge of labor product product product
0 0 2000 1 ? 2000 1000 2 3
000 1500 ? 3 3500 1167
300 4 3800 950 100 5 3900 ?
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4000
3000
3000
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Marginal product (per unit of labor)
2000
2000
Total product
1000
1000
0
1
2
3
4
5
1
2
3
4
5
Labor
Labor
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4000
3000
Marginal product (per unit of labor)
2000
Total product
1000
0
1
2
3
4
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Labor
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4000
3000
3000
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Marginal product (per unit of labor)
2000
2000
Total product
1000
1000
0
1
2
3
4
5
1
2
3
4
5
Labor
Labor
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The Shapes Of Both Curves

• It should be clear that a rising marginal cost
  curve must follow directly from a falling
  marginal product curve.
• Moreover, the shapes of both curves are
  attributable to the law of diminishing returns.

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A Red Flag

• I'll use these red flags when I want to make an
  important point.

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Marginal Cost

• The concept of marginal cost is one of the most
  essential in microeconomics.
• As we shall learn in a later chapter, competitive
  firms will produce at a level where the price of
  the product equals their marginal cost.
• PMC

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The Supply Curve
MC
AC
AVC
Aggregate and marginal cost (dollars)
The supply curve is that portion of the marginal
cost curve above the average variable cost curve.
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q
Quantity
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156
4.54 9.64 14.18 17 50 150 200 ?
8.82 11.76 7 18 50 157 207 ?
8.72 11.50 21 50 182 232 2.38
8.67 ? 23 50 200 250 2.17
8.70 ? 10 24 50 210 260 2.08
? 10.83 28 50 250 300 1.79
? 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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1 2 3 4 5 6 7 8 Marginal
costs Average Average variable Average total
Fixed Variable Total
(MC) fixed costs fixed costs
costs (ATC) costs costs
costs (change in (AFC)
(AVC) (ATC) Output (FC)
(VC) (TC) total costs) FC/Output
VC/Output AFCAVC
4 50 50 100 12.50 12.50 25.00 10
5 50 60 110 10.00 12.00 22.00 10 50 100
150 5.00 10.00 15.00 6 11 50 106 156
4.54 9.64 14.18 17 50 150 200 2.94
8.82 11.76 7 18 50 157 207 2.78
8.72 11.50 21 50 182 232 2.38
8.67 11.05 23 50 200 250 2.17
8.70 10.87 10 24 50 210 260 2.08
8.75 10.83 28 50 250 300 1.79
8.93 10.72 15 29 50 265 315 1.72
9.14 10.86 32 50 350 400 1.56 10.94 12.50
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AFC, AVC And AC Curves
Aggregate and marginal cost (dollars)
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q
Quantity
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AFC, AVC And AC Curves

• The AFC curve approaches zero because as a firms
  output increases, it spreads its fixed costs over
  a larger number of units so average fixed costs
  must fall.
• For the same reason, the AVC curve must approach
  the ATC curve as output increases.

Aggregate and marginal cost (dollars)
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q
Quantity
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A Trickier Question

• We know why the ATC, AVC, and MC curves slope
  first down and then up--it's the law of
  diminishing returns.
• But why does the MC curve intersect both the AVC
  and AC curves at their minimums?

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• If MCgtATC, then ATC is rising.
• If MCATC, then ATC is at its low point.
• If MCltATC, then ATC is falling.

• If the production of an additional unit has a
  marginal cost greater than the average cost, then
  production of that unit must drive the average
  up, and conversely.
• Thus, it must be that only when MCATC that the
  ATC is at its lowest point.

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MCATC

• It means that a firm searching for the lowest
  average cost of production should look for the
  level of output at which marginal cost equals
  average cost.

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MC
Area C
Area A
ATC
Area B
Costs per unit
AVC
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Quantity
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The Power Of Marginal Analysis

• When marginal cost is coupled with the concept of
  marginal revenue the firm is able to determine if
  it is profitable to expand or contract its
  production level.
• The analysis in the next several lectures centers
  on these types of marginal calculations.

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End Of Part 1
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voiceover Ashley West Leonard