Chapter 4: Marginal Cost

Definition
Marginal cost is the change in the total cost that arises when the quantity produced increases
by one unit. Marginal cost includes the cost of labor and materials but not the fixed costs of the
factory that have already been incurred.
Law of Diminishing Return

Most firms will eventually face increasing average costs as they try to increase output. The firm
finds that each extra unit of output requires more inputs to produce than previous units, this is
called the law of diminishing returns.
Diminishing marginal returns occur for a variety of reasons:
1. Difficulty of monitoring and motivating a larger workforce – managing a few workers is
easier than controlling numerous workers. For example: if 5 workers produce 100 units
it doesn’t mean that 50 workers will produce 1,000 units.
2. Increasing the complexity of the larger system – as the business expands, so are the
expansion of systems that might things like communication to management, the
establishment of different departments that requires manpower, and a salary increase.
3. Office norms – if the company is divided into different departments, stations, etc.,
offices might develop negative norms that might reduce the productivity of workers.
Economies of Scale

The law of diminishing marginal returns is primarily a short-run phenomenon over the long run
you could overcome the reasons why returns diminished, managers will be hired to motivate
workers, complex systems will start to function and bring more income to the business,
negative office norms will be controlled through audits, monitoring, and evaluation.
Economies of scale can result from a variety of areas. Larger firms can benefit more from capital
equipment like machinery, the company increased their production capacity. Larger firms also
receive discounts for buying in bulk or creating favorable deals with suppliers. Because
production capacity increased through the purchase of new machinery the firm could now offer
bulk discounts to maximize its production capacity. Generally, customers trust large firms more
than small firms, and demand for products produced by large firms is greater.
Economies of scale are vital for the survival of large firms like Uniliver, Lucky me, etc., because
their production cost is lower compared to the production cost that an individual will incur if
he/she decides to produce their version of the products. It means that they could price lower
than the cost of rising competitors and still earn profit but their competitors will not be able to
earn a profit because they cannot price the product lower than the cost.
If in the long-run average costs fall with output, you have increasing returns to scale or
economies of scale.
Diseconomies of Scale
Sometimes even, in the long run, the cause of diminishing marginal returns may not be solved.
Management is an important input into the production process. Diseconomies of scale happen
if long-run average costs rise with output.
Economies of Scope
Economies of scope mean that producing one product will reduce the production cost of the
other product. The product has economies of scope if the cost of producing the two products
jointly is less than the cost of producing the two products separately.
Cost (Q1,Q2) < Cost (Q1) + Cost (Q2)
The cost of producing the product jointly will be cheaper if (1) one of the products is a by-
product of the other product. Example: it is cheaper to make graham cracker crumbs using
defects or destroyed graham crackers than making graham cracker crumbs out of good graham
crackers because it reduces the cost of defects (2) the two product has the same process.
Example: in making classic bread and chocolate flavored bread, both products have the same
process in making the dough so a large dough is made at the start reducing the cost and time,
the dough then separates into two, one for the classic bread and one for the chocolate flared
bread. (3) they use the same equipment and facility, using the same equipment and facility
saves the firm some depreciation expense compared to producing the two products separately.
Diseconomies of scope
If the cost of producing the two products separately is less than the cost of producing the
product jointly. Producing two products might expand the business subjecting it to the law of
diminishing returns.
Learning curve

A newly hired employee tends to be less productive than an experienced employee, a newly
hired might produce 10 units a day but an experienced employee produces 20 units. In the next
month, the newly hired employees now produce 12 units per day, this is called Learning Curve.
If the salary of the new employee is 480/day this means that the labor cost per unit in the first
month is 48/per unit while in the second month it is 40/per unit.
For example, if it takes 100 minutes to assemble the first laptop and the learning curve is 80%
then on the second laptop it will take 80 minutes (100 x 80%) and on the fourth laptop, it will
take 70.2 minutes (100 x 80%). The learning curve means that every time the attempts doubled
the time to produce decreased by 20%. A mathematical formula is used to compute the 3 rd unit:
Tn = T1 (N (log L/log2))

Where in
Tn = Time required to Complete the Nth Unit
T1 = Time required to Complete the 1st Unit
N = Nth Unit
L
= Learning Curve

In the previous example, the time required to complete the 3rd unit is =

T3 = 100minutes (3 (log 80%/log2))

T3 = 70.21 minutes

Another problem is the computation of the cumulative time to produce all the products. In the
previous example, the cumulative time to finish 3 units is 250.21 minutes (100 + 80 + 70.21)
then how much time is needed to produce 150 units, it would be time-consuming to compute
each unit separately and then add them, to summarize the formula is:
K = [(N(1+[log L/log 2]))/([Tn+0.5(1+[log L/log 2])] – T1-0.5(1+[log L/log 2]))](-1/[log L/log 2])
C = [T1(K) (log L/log 2) * ]N

Where in
Tn = Time required to Complete the Last Unit
T1 = Time required to Complete the 1st Unit
N = Nth Unit
L
= Learning Curve

What is the cumulative time to produce 3 units:

K = [3(0.678)]/([3.50.678] – [0.50.678])-1/-0.322
K = [2.0342157/(2.338391655 – 0.625000)]3.10559
K = [2.0342157/1.713391655]3.10559
K = [1.187245014]3.10559
K = 1.704272691
C = [100 (1.704272691)-0.322]* 3
C = [100 (0.8422946792)] * 3
C = 84.22946792 * 3
C = 252.688 minutes
The formula will not compute the actual cumulative time but close to the answer
Using the same formula we can compute the cumulative time to complete jobs through
different units; the cumulative time to complete 3 to 6 units is:
K = [(N(1+[log L/log 2]))/([Tn+0.5(1+[log L/log 2])] – T1-0.5(1+[log L/log 2]))](-1/[log L/log 2])
K= [4(.678)/(6.5.678 - 2.5.678)]1/.322
K = [2.712/(3.55758 - 1.86124)]3.10559
K = 4.2938
C = 100(4.29385)-.322 * 4
C = 62.5494 * 4
C = 250.1974
Computing it individually:
T3 = 70.2
T4 = 64.0
T5 = 59.6
T6 = 56.2
 C = 250 minutes

Computation of Learning Curve

The formula is

C = N1+b

Wherein:
C = Cumulative Time
N = Number of units
b = Slope

For example, assume two lots have been produced, one lot contained 2 units and a second lot
contained 4 more units.

Substituting the Formula

72 = (2)1+b
183 = (6)1+b

Converting these to the log forms we have:

log 72 = (log 2) (1 + b)
log 183 = (log 6) (1 + b)

Calculating the log values indicated we have:

1.8575 = (0.301) (1 + b)
2.2625 = (.7782) (1 + b)
1.8575 =.301 + .301b
2.2625 =.7782 + .7782b

Subtracting the first equation from the second equation provides the following equation which
can easily be solved for b.

.405 = .4772 + .4772b

b = -.151299
b = log of learning rate/log of 2
-.151 = Log of learning rate / .301
log of learning rate = -.151(.301) = -.04545
The learning rate = the antilog = 10-.04545 = .90
Problems
1. Microsoft found that instead of producing a DVD player and a gaming system
separately, it is cheaper to incorporate DVD-playing capabilities in its new versions of
the gaming system. Microsoft is taking advantage of
a. Economies of scale
b. Learning curve
c. Economies of scope
d. Decreasing marginal cost
2. As a golf club production company produces more clubs, the average total cost of each
club produced decreases This is because.
a. Total fixed costs are decreasing as more clubs are produced.
b. Average variable cost is decreasing as more clubs are produced
c. There are scale economies
d. Total variable cost is decreasing as more clubs are produced
3. Average costs curves initially fall
a. Due to declining average fixed costs
b. Due to rising average fixed costs
c. Due to declining accounting costs
d. Due to rising marginal costs
4. What might you reasonably expect of an industry in which firms end to have economies
of scale?
a. Exceptional competition among firms
b. A large number of firms
c. Highly diversified firms
d. A small number of firms
5. A security system company’s total production costs depend on the number of systems
produced according to the following equation: Total Costs = P20,000,000 + 4,000 *
Quantity produced. Given these data, which of the following is a false statement?
a. There are economies of scale
b. There are fixed costs associated with this business
c. There are diseconomies of scale
d. A firm that produces a larger output has a cost advantage over a small firm.
6. Following are the costs to produce product A. product B, and products A and B together.
Which of the following exhibits economies of scope?
a. 100, 150, 240
b. 100, 150, 250
c. 100, 150, 260
d. All of the above
7. According to the law of diminishing marginal returns, marginal returns
a. Diminished always before increasing
b. Diminished constantly
c. Diminished never
d. Diminished eventually
8. It costs a firm P90 per unit to produce product A and P70 per unit to produce product B
individually. If the firm can produce both products together at P175 per unit of products
A and B, this exhibits signs of
a. Economies of scale
b. Economies of scope
c. Diseconomies of scale
d. Diseconomies of scope
9. A company faces the following costs at the respective production levels in addition to its
fixed costs of P50,000

Quantity Marginal Cost Sale Price Marginal Returns

1 10,000 20,000 10,000
2 11,000 20,000 9,000
3 12,000 20,000 8,000
4 13,000 20,000 7,000
5 14,000 20,000 6,000
How would you describe the returns to scale for this company?
a. Increasing
b. Decreasing
c. Constant
d. Marginal
10. Once marginal cost rises above the average cost.
a. Average costs will increase
b. Average costs are unaffected
c. Average costs will decrease
d. None of the above
11. Supposeosed Nike’s manager was considering expanding into producing sports
beverages, why might the company decide to do this under the Nike brand name?
12. Learning Curve
T1 Learning Curve
20 hrs 70%
10 hrs 60%
Solve for the time required to complete the:
a. 21st unit
b. 35th unit
c. 50th unit
How much is the cumulative time to complete
a. 1st – 20th unit
b. 5th – 25th unit