A firm has three different production facilities, all of which produce the same

Question

A firm has three different production facilities, all of which produce the same product. While reviewing the firm’s cost data, Jasmin, a manager, discovers that one of the plants has a higher average cost than the other plants and suggests closing that plant. Another manager, Joshua, notes that the high-cost plant has high fixed costs but that the marginal cost in that plant is lower than in the other plants. He says that the high-cost plant should not be shut down but should expand its operations. Who is right?

Explanation / Answer

Joshua is right.

Fixed cost is a form of unavoidable cost which would be incurred even if the firm stops operations. Therefore, the relevant cost is not the fixed cost. Similarly, average cost is not the suitable yardwtick either, since average cost takes into consideration both the variable cost and fixed cost.

The marginal cost (MC) is the cost of producing one additional unit of output, which is the yardstick for measuring the cost of day-to-day operations. Therefore, if a firm has high average cost but low marginal cost, such a firm should not shut down, and would try to increase production.

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