What is Marginal Cost?
Marginal cost is one of the most fundamental principles in economics, which is essential to any business’s financial analysis when evaluating the prices of goods and services. This basic principle is used in financial modelling to generate and regulate cash flow.
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Define Marginal Cost
The marginal cost is the additional cost incurred in producing other units of goods and services. These goods and services usually belong to the manufacturing sector of the economy.
You can calculate the marginal cost by dividing the change in the prices by the change in quantity, resulting in the fixed costs for the items already produced. Additionally, there’s the variable cost, too, which needs to be accounted for in the manufacturing process.
The marginal cost of production includes all the expenses that are incurred with that level of production. When the marginal cost of producing any additional items is lower than the price per unit, the manufacturer may be able to gain a profit from it.
When you start plotting the marginal costs on a graph sheet, you will see a U-shaped curve when the prices are high. However, it shifts and starts going down as the production increases. Then, there’s a rise that happens after some point.
How to Calculate the Marginal Cost?
Before you start calculating marginal cost, you need to understand two concepts: change in prices and change in quantity.
Change in Costs: There may be an increase or decrease in the prices in the production process. It is likely to happen when the manufacturing needs to increase or decrease the output volume. For example, if the production process requires two more workers to meet the output, it would change the costs. The difference in cost is calculated by subtracting the production costs in the first run from production costs in the next one.
Change in Quantity: In the process of production, the amount of product can increase or decrease. The quantities should be sufficient to evaluate the changes in the cost. For example, if 4000 pairs of shoes were made in the initial production run but 9000 more need to be made, you can calculate the change in the quantity by deducting the number of shoes made in the first run from the volume of the output of the next.
Marginal Cost Formula
If you want to calculate the marginal cost of production, you need to know the marginal cost formula. The marginal cost equation is as follows:
Marginal cost = \[ \frac {\text {Changes in costs}} {\text{Changes in Quantity}}\]
Example:
If you look at the table below, it contains the data to calculate the marginal costs:
Marginal cost = \[\frac{ $ 250000-225000}{3000-2000}\]
Marginal cost = \[\frac{ $ 250000-225000}{1000}\]
Marginal cost = $ 25
How to Calculate Marginal Cost
You can use the marginal cost formula and calculate the marginal cost of production of a particular good. Here’s an example of calculating the marginal cost of production.
ABC is a public company that manufactures 12,000 units of mattresses every year, incurring production costs of $ 4 million. However, their demand for beds increases the following year, which leads to the market in the production of more units. The increase in demand forces the management to hire more people and purchase more materials. This demand for mattresses leads to an overall production cost of $ 8 million to produce 20,000 beds. Determine the marginal cost of the production.
Marginal cost = \[ \frac{${ \text {4 million Changes in costs}}} {\text{8000 Changes in Quantity}} \]
Marginal cost = $ 500
Long Run and Short Run Marginal Costs
Long Run Marginal Cost
Long-run costs are incurred by a firm changing the production levels over a period of time as a response to the expected economic profits or losses. The fixed factors of production are absent in the long run. This is a stage where producers plan and implement those plans to gain profits.
Short-Run Marginal Cost
Short-run marginal costs are costs incurred by a firm in a short period of time. This cost can be related to a good, a service or the quantity of output produced by the firm. In the short run, the firm incurs both fixed and variable costs. The variable costs keep changing with the change in the output of the firm.
Relationship between Total Cost and Marginal Cost
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When the Marginal cost increases the total cost also increases at an increasing rate. This continues till the point when the marginal cost curve reaches its maximum point.
When the Marginal cost declines but remains positive, the total cost continues to increase but at a decreasing rate. This continues till the total cost curve reaches its maximum.
When the marginal cost curve is declining, while remaining positive, the total cost curve declines.
When the marginal cost curve becomes zero, the total cost curve reaches its maximum point.
Relationship between Average Cost and Marginal Cost
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When average cost falls, marginal cost is lower than average cost:
If the average cost falls, the marginal cost is lower than the average cost. In the diagram, the average cost falls till it reaches a certain point, and the marginal cost remains less than that point. The average cost falls till point E, and the marginal cost continues to be lower than the average cost. This is why the marginal cost (MC) curve falls below the average cost (AC) curve.
When average cost rises, marginal cost is more significant than average cost.
When AC starts to rise, the MC is greater than AC. When average cost starts rising from point E, marginal cost is higher than average cost.
When average cost doesn’t change, marginal cost is equal to average cost.
If AC doesn’t change, then marginal cost = average cost. This happens when the falling average cost reaches its low point. The marginal cost curve intersects the average cost curve at its minimum point, which is E.
What are the Benefits of Marginal Costs?
When a business conducts financial analysis, one of the best tools for calculating its marginal cost of production, here are some of the benefits of the marginal cost of production:
It helps in concentrating resources where excess marginal revenue over the marginal costs are at its highest.
Marginal costs allow for an increase and decrease in product prices, which help a company evaluate how much they will have to pay to produce more items.
It helps companies determine how much cost advantage they can achieve through efficient production to optimise overall production in the company.
Marginal costs may decrease the overall cost of making a product line.
Conclusion
Marginal cost is a very important concept in economics. It’s essential that you go through this concept thoroughly and understand it properly. When you know the concept of marginal costs, you will be able to use it as necessary in the future. Along with learning what marginal cost is, you will learn the total cost and average cost. All three concepts are easy and simple to understand.
FAQs on Marginal Cost Formula and Its Applications
1. What is the basic formula for calculating marginal cost?
The formula to calculate marginal cost (MC) is the change in total cost divided by the change in the quantity of output. It is expressed as: MC = ΔTC / ΔQ, where ΔTC represents the change in total costs and ΔQ represents the change in quantity produced. This formula helps determine the cost of producing one additional unit of a good or service.
2. How can you calculate marginal cost from a table with a simple example?
To calculate marginal cost from a table, you need production data at two different levels. For example, a company produces 100 units at a total cost of ₹5,000. It then increases production to 120 units, and the total cost rises to ₹5,800.
Here’s how to calculate it:
- Change in Total Cost (ΔTC) = ₹5,800 - ₹5,000 = ₹800
- Change in Quantity (ΔQ) = 120 units - 100 units = 20 units
- Marginal Cost (MC) = ΔTC / ΔQ = ₹800 / 20 = ₹40 per unit.
This means the marginal cost to produce each of the additional 20 units is ₹40.
3. What is the relationship between Marginal Cost (MC) and Average Cost (AC)?
The relationship between Marginal Cost (MC) and Average Cost (AC) is fundamental to understanding a firm's cost structure. There are three key scenarios:
- When MC is less than AC (MC < AC), the average cost is falling. Adding a unit that costs less than the average pulls the average down.
- When MC is greater than AC (MC > AC), the average cost is rising. Adding a unit that costs more than the average pushes the average up.
- When MC is equal to AC (MC = AC), the average cost is at its minimum point. This is the point of productive efficiency, where the MC curve intersects the AC curve from below.
4. Why is the marginal cost curve typically U-shaped in the short run?
The U-shape of the short-run marginal cost curve is explained by the Law of Variable Proportions (or Law of Diminishing Returns).
- Initially, MC falls: When production starts, increasing returns to a variable factor (like labour) lead to greater efficiency. The marginal product increases, meaning each additional unit costs less to produce than the previous one.
- Then, MC rises: After a certain point, diminishing returns set in. The fixed factors (like machinery) become overburdened, and each additional variable input becomes less productive. The marginal product decreases, causing the marginal cost of producing each extra unit to rise.
5. How is the marginal cost concept applied in real-world business decisions?
Businesses use marginal cost analysis for several critical decisions:
- Pricing Strategy: It helps set the minimum price for a product. A business should not sell a product for less than its marginal cost in the short run.
- Production Levels: Comparing marginal cost to marginal revenue (MC vs. MR) helps a company decide whether to produce one more unit. Production is profitable as long as MR > MC.
- Shutdown Decisions: If the market price falls below the average variable cost, a firm may decide to shut down production temporarily, as it cannot even cover the marginal costs of production.
- Evaluating Special Orders: It helps in deciding whether to accept a one-time special order at a price that is below the total average cost but above the marginal cost.
6. What is the main difference between short-run marginal cost and long-run marginal cost?
The primary difference lies in the nature of costs. In the short run, at least one factor of production is fixed (e.g., factory size). Therefore, short-run marginal cost (SMC) reflects the change in only the variable costs (like labour and materials) when output changes. In the long run, all factors of production are variable. A firm can change its factory size, machinery, and all other inputs. Therefore, long-run marginal cost (LMC) reflects the change in total cost when all inputs are adjusted for optimal efficiency at a new output level.
7. Can marginal cost ever be negative?
No, marginal cost cannot be negative. The total cost of production can never decrease when you produce an additional unit of a good. At best, the marginal cost can be zero in some rare theoretical cases, such as the reproduction of a digital good (like a software copy or an MP3 file) where the cost of making one more copy is virtually nil. However, in the physical production of goods and services as per the CBSE syllabus, producing more will always incur at least some small additional cost for materials or energy, so MC will remain positive.
