Marginal cost

Marginal cost
See also
Real cost Profit maximization Average cost method Financial break even point Salvage value Manufacturing overhead (MOH) Manufacturing cost Factory price Perfectly inelastic demand

Marginal cost is the incremental cost incurred with producing one more unit of a good or service. In other words, it is the cost associated with producing an extra unit of a good or service. Marginal cost typically includes all variable costs, such as labor and materials, as well as any additional fixed costs associated with the production of the extra unit.

An example of marginal cost can be seen in the production of cars. If a car manufacturer produces 200 cars in a month, the marginal cost is the cost associated with producing the 201st car.

Marginal cost is an important concept in economics, as it helps to determine the optimal level of production for a firm. This is because the marginal cost of production represents the cost of producing an additional unit of a good or service. Thus, if the marginal cost is greater than the price that a company can charge, it is not beneficial to produce the additional unit. However, if the marginal cost is less than the price that a company can charge, then it is beneficial to produce the additional units.

Example of Marginal cost

• Labor: If a business increases the number of employees to produce an additional unit, then the marginal cost would include the wages of the new employee.
• Materials: If a business needs to purchase additional raw materials to produce the additional unit, then the marginal cost would include the cost of the materials.
• Overhead: If a business incurs additional overhead costs to produce the additional unit, such as additional electricity or rent, then the marginal cost would include the overhead costs.

In summary, marginal cost includes all variable costs and any additional fixed costs associated with the production of an extra unit, such as labor, materials, and overhead.

Formula of Marginal cost

The formula for marginal cost is:

$MC={\frac {\Delta TC}{\Delta Q}}$

where MC is the marginal cost, Δ TC is the change in total costs, and Δ Q is the change in output.

When to use Marginal cost

Marginal cost can be used in a variety of situations. It can be used to:

• Determine the optimal level of production for a firm: By comparing the marginal cost of production to the price that the firm can charge, the firm can determine the optimal level of production.
• Make decisions about pricing: By comparing the marginal cost of production to the price that customers are willing to pay, the firm can determine the optimal price for its products.
• Make decisions about outsourcing: By comparing the marginal cost of production to the cost of outsourcing, the firm can determine whether it is more cost-effective to produce the good or service itself or to outsource it.

Types of Marginal cost

Marginal cost typically includes all variable costs, such as labor and materials, as well as any additional fixed costs associated with the production of the extra unit. There are three types of marginal cost:

• Variable cost: These are costs that vary directly with the level of output. Examples include the cost of raw materials, wages, and other variable costs.
• Fixed cost: These are costs that do not vary directly with the level of output. Examples include rent, insurance, and other fixed costs.
• Sunk cost: These are costs that have already been incurred and cannot be recovered. Examples include research and development costs and other sunk costs.

Steps of Marginal cost

• Step 1: Calculate the total cost of production. This includes all costs associated with production, including labor, materials, and any additional fixed costs.
• Step 2: Calculate the change in total cost. This is done by subtracting the total cost of the previous production period from the total cost of the current production period.
• Step 3: Calculate the change in output. This is done by subtracting the output of the previous production period from the output of the current production period.
• Step 4: Calculate the marginal cost. This is done by dividing the change in total cost by the change in output.

Advantages of Marginal cost

• Marginal cost provides an efficient way to calculate the cost of producing an additional unit of output.
• It can help businesses to determine the optimum level of output, as it allows them to calculate the additional costs associated with producing an extra unit.
• It helps businesses to determine pricing strategies that will maximize profits.

Disadvantages of Marginal cost

• It does not take into account the opportunity cost of producing the additional unit.
• It does not take into account the long-term costs associated with producing the additional unit.
• It does not take into account the fixed costs associated with producing the additional unit.

In summary, the advantages of marginal cost include providing an efficient way to calculate the cost of producing an additional unit of output, helping businesses to determine the optimum level of output, and helping businesses to determine pricing strategies that will maximize profits. The disadvantages of marginal cost include not taking into account the opportunity cost of producing the additional unit, not taking into account the long-term costs associated with producing the additional unit, and not taking into account the fixed costs associated with producing the additional unit.

Limitations of Marginal cost

There are several limitations of marginal cost. These include:

• It does not take into account the time value of money: Marginal cost does not consider the time value of money, meaning that it does not take into account the costs associated with delaying production, such as the opportunity cost of not investing the money in something else.
• It does not consider the effect of fixed costs: Marginal cost does not take into account the effect of fixed costs, such as the costs associated with setting up the production process or maintaining the machinery used in production.
• It does not consider the effect of externalities: Marginal cost does not take into account the effect of externalities, such as the environmental costs of production or the effect of production on the local community.

Other approaches related to Marginal cost

• Average Variable Cost (AVC): Average variable cost is the total variable cost divided by the number of units produced. Mathematically, it can be expressed as:

$AVC={\frac {TVC}{Q}}$

where AVC is the average variable cost, TVC is the total variable cost, and Q is the number of units produced.

• Average Total Cost (ATC): Average total cost is the total cost of production divided by the number of units produced. Mathematically, it can be expressed as:

$ATC={\frac {TC}{Q}}$

where ATC is the average total cost, TC is the total cost, and Q is the number of units produced.

In summary, there are several approaches related to marginal cost including average variable cost and average total cost. These approaches are used to calculate the cost of production and the optimal level of production for a firm.

Suggested literature

• Coase, R. H. (1946). The marginal cost controversy. Economica, 13(51), 169-182.
• Hall, R. E. (1988). The relation between price and marginal cost in Us industry. Journal of political Economy, 96(5), 921-947.