In economics, marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good. Intuitively, marginal cost at each level of production includes the cost of any additional inputs required to produce the next unit. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, whereas other costs that do not vary with production are fixed and thus have no marginal cost. For example, the marginal cost of producing an automobile will generally include the costs of labor and parts needed for the additional automobile but not the fixed costs of the factory that have already been incurred. In practice, marginal analysis is segregated into short and long-run cases, so that, over the long run, all costs (including fixed costs) become marginal. Where there are economies of scale, prices set at marginal cost will fail to cover total costs, thus requiring a subsidy. Marginal cost pricing is not a matter of merely lowering the general level of prices with the aid of a subsidy; with or without subsidy it calls for a drastic restructuring of pricing practices, with opportunities for very substantial improvements in efficiency at critical points.
If the cost function is continuous and differentiable, the marginal cost is the first derivative of the cost function with respect to the output quantity :
The marginal cost can be a function of quantity if the cost function is non-linear. If the cost function is not differentiable, the marginal cost can be expressed as follows:
where denotes an incremental change of one unit.
Short run marginal cost is the change in total cost when an additional output is produced in the short run. Based on the Short Run Marginal Cost graph on the right side of the page, SMC forms a U-shape in a graph where the x-axis displays the quantity and the y-axis costs. Cost curves are all U-shaped due to the law of variable proportions. This includes marginal costs together with average variable costs and average total costs.
On the short run, firms often have a fixed number of assets (eg. equipment, machinery). The firm owner can choose to increase or decrease productivity with the current amount of assets he has. When choosing to increase or decrease productivity, there is a single point where the unit cost reaches the minimum level (lowest point of marginal cost). At this point, the short-run average total cost is utilized with the optimal combination of both variable and fixed cost.
Fixed factors of production in the long run does not exist, therefore, we will not be using the fixed and variable factors. The concept is fairly similar to short run marginal cost minus the application of fixed cost. As seen in the graph, there are fixed costs.
In the simplest case, the total cost function and its derivative are expressed as follows, where Q represents the production quantity, VC represents variable costs, FC represents fixed costs and TC represents total costs.
Fixed costs represent the costs that do not change as the production quantity changes. Fixed costs are costs incurred by things like rent, building space, machines, etc. Variable costs change as the production quantity changes, and are often associated with labor or materials. The derivative of fixed cost is zero, and this term drops out of the marginal cost equation: that is, marginal cost does not depend on fixed costs. This can be compared with average total cost (ATC), which is the total cost (including fixed costs, denoted C0) divided by the number of units produced:
For discrete calculation without calculus, marginal cost equals the change in total (or variable) cost that comes with each additional unit produced. Since fixed cost does not change in the short run, it has no effect on marginal cost.
For instance, suppose the total cost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. The marginal cost of producing shoes decreases from $30 to $10 with the production of the second shoe ($40 – $30 = $10).
Marginal cost is not the cost of producing the "next" or "last" unit. The cost of the last unit is the same as the cost of the first unit and every other unit. In the short run, increasing production requires using more of the variable input — conventionally assumed to be labor. Adding more labor to a fixed capital stock reduces the marginal product of labor because of the diminishing marginal returns. This reduction in productivity is not limited to the additional labor needed to produce the marginal unit – the productivity of every unit of labor is reduced. Thus the cost of producing the marginal unit of output has two components: the cost associated with producing the marginal unit and the increase in average costs for all units produced due to the "damage" to the entire productive process. The first component is the per-unit or average cost. The second component is the small increase in cost due to the law of diminishing marginal returns which increases the costs of all units sold.
Marginal costs can also be expressed as the cost per unit of labor divided by the marginal product of labor. Denoting variable cost as VC, the constant wage rate as w, and labor usage as L, we have
Here MPL is the ratio of increase in the quantity produced per unit increase in labour: i.e. ΔQ/ΔL, the marginal product of labor. The last equality holds because is the change in quantity of labor that brings about a one-unit change in output. Since the wage rate is assumed constant, marginal cost and marginal product of labor have an inverse relationship—if the marginal product of labor is decreasing (or, increasing), then marginal cost is increasing (decreasing), and AVC = VC/Q=wL/Q = w/(Q/L) = w/APL
While neoclassical models broadly assume that marginal cost will increase as production increases, several empirical studies conducted throughout the 20th century have concluded that the marginal cost is either constant or falling for the vast majority of firms. Most recently, former Federal Reserve chair Alan Blinder and colleagues conducted a survey of 200 executives of corporations with sales exceeding $10 million, in which they were asked, among other questions, about the structure of their marginal cost curves. Strikingly, just 11% of respondents answered that their marginal costs increased as production increased, while 48% answered that they were constant, and 41% answered that they were decreasing.:106 Summing up the results, they wrote:
...many more companies state that they have falling, rather than rising, marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalized in textbooks.— Asking About Prices: A New Approach to Understanding Price Stickiness, p. 105
Many Post-Keynesian economists have pointed to these results as evidence in favor of their own heterodox theories of the firm, which generally assume that marginal cost is constant as production increases.
Economies of scale apply to the long run, a span of time in which all inputs can be varied by the firm so that there are no fixed inputs or fixed costs. Production may be subject to economies of scale (or diseconomies of scale). Economies of scale are said to exist if an additional unit of output can be produced for less than the average of all previous units – that is, if long-run marginal cost is below long-run average cost, so the latter is falling. Conversely, there may be levels of production where marginal cost is higher than average cost, and the average cost is an increasing function of output. Where there are economies of scale, prices set at marginal cost will fail to cover total costs, thus requiring a subsidy. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the marginal cost curve intersects the average cost curve from below).
The portion of the marginal cost curve above its intersection with the average variable cost curve is the supply curve for a firm operating in a perfectly competitive market (the portion of the MC curve below its intersection with the AVC curve is not part of the supply curve because a firm would not operate at a price below the shutdown point). This is not true for firms operating in other market structures. For example, while a monopoly has an MC curve, it does not have a supply curve. In a perfectly competitive market, a supply curve shows the quantity a seller is willing and able to supply at each price – for each price, there is a unique quantity that would be supplied.
In perfectly competitive markets, firms decide the quantity to be produced based on marginal costs and sale price. If the sale price is higher than the marginal cost, then they produce the unit and supply it. If the marginal cost is higher than the price, it would not be profitable to produce it. So the production will be carried out until the marginal cost is equal to the sale price.
Marginal costs are not affected by the level of fixed cost. Marginal costs can be expressed as ∆C∕∆Q. Since fixed costs do not vary with (depend on) changes in quantity, MC is ∆VC∕∆Q. Thus if fixed cost were to double, the marginal cost MC would not be affected, and consequently, the profit-maximizing quantity and price would not change. This can be illustrated by graphing the short run total cost curve and the short-run variable cost curve. The shapes of the curves are identical. Each curve initially increases at a decreasing rate, reaches an inflection point, then increases at an increasing rate. The only difference between the curves is that the SRVC curve begins from the origin while the SRTC curve originates on the positive part of the vertical axis. The distance of the beginning point of the SRTC above the origin represents the fixed cost – the vertical distance between the curves. This distance remains constant as the quantity produced, Q, increases. MC is the slope of the SRVC curve. A change in fixed cost would be reflected by a change in the vertical distance between the SRTC and SRVC curve. Any such change would have no effect on the shape of the SRVC curve and therefore its slope MC at any point. The changing law of marginal cost is similar to the changing law of average cost. They are both decrease at first with the increase of output, then start to increase after reaching a certain scale. While the output when marginal cost reaches its minimum is smaller than the average total cost and average variable cost. When the average total cost and the average variable cost reach their lowest point, the marginal cost is equal to the average cost.
The marginal cost intersects with the average total cost and the average variable cost at their lowest point. Take the [Relationship between marginal cost and average total cost] graph as a representation.
Say the starting point of level of output produced is n. Marginal cost is the change of the total cost from an additional output [(n+1)th unit]. Therefore, (refer to "Average cost" labelled picture on the right side of the screen.
In this case, when the marginal cost of the (n+1)th unit is less than the average cost(n), the average cost (n+1) will get a smaller value than average cost(n). It goes the opposite way when the marginal cost of (n+1)th is higher than average cost(n). In this case, The average cost(n+1) will be higher than average cost(n). If the marginal cost is found lying under the average cost curve, it will bend the average cost curve downwards and if the marginal cost is above the average cost curve, it will bend the average cost curve upwards. You can see the table above where before the marginal cost curve and the average cost curve intersect, the average cost curve is downwards sloping, however after the intersection, the average cost curve is sloping upwards. The U-shape graph reflects the law of diminishing returns. A firm can only produce so much but after the production of (n+1)th output reaches a minimum cost, the output produced after will only increase the average total cost ( Nwokoye, Ebele & Ilechukwu, Nneamaka ,2018).
The profit maximizing graph on the right side of the page represents optimal production quantity when both The marginal cost and the marginal profit line intercepts. The Black line represents the intersection where the profits are the greatest ( Marginal revenue = marginal cost). The left side of the black vertical line marked as “profit-maximising quantity” is where the marginal revenue is larger than marginal cost. If a firm sets its production on the left side of the graph and decides to increase the output, the additional revenue per output obtained will exceed the additional cost per output. From the “profit maximizing graph”, we could observe that the revenue covers both bar A and B, meanwhile the cost only covers B. Of course A+B earns you a profit but the increase in output to the point of MR=MC yields extra profit that can cover the revenue for the missing A. The firm is recommended to increase output to reach (Theory and Applications of Microeconomics, 2012).
On the other hand, the right side of the black line (Marginal revenue = marginal cost), shows that marginal cost is more than marginal revenue. Suppose a firm sets its output on this side, if it reduces the output, the cost will decrease from C and D which exceeds the decrease in revenue which is D. Therefore, decreasing output until the point of (marginal revenue=marginal cost) will lead to an increase in profit (Theory and Applications of Microeconomics, 2012).
Nwokoye, Ebele & Ilechukwu, Nneamaka. (2018). CHAPTER FIVE THEORY OF COSTS.
2012. Theory And Applications Of Microeconomics. [Place of publication not identified]: [publisher not identified].