What is Marginal Cost?

The marginal cost is a concept used in economics and seeks to describe the changes caused in the total cost for a unit change in the quantity produced.

As the marginal cost is higher, it means that a greater proportion has been added to the total costs. If there is a decrease in the marginal cost, the total costs grow at an ever lower rate.

The marginal cost analysis is important to understand the extent to which costs grow as a company wants to produce more. After a certain point, and depending on the technology used, increasing the quantities requires an incremental increase in costs.

In addition, with an increase in production it is possible to compare the increase in revenue with the additional quantity to be sold, in this case known as marginal revenue.

The activity may be viable if the variation in the yields obtained is greater than or equal to the variation in costs, through the marginal cost.

The marginal cost can be compared to the average cost for a certain level of production. The average of a cost is measured by the total cost divided by the quantity.

Calculating marginal cost

The marginal cost can be calculated by varying the total cost by the quantity added. The variation of the total total cost (TC) is measured, less the previous one, with the variation of the quantity (Q).

In the case where a function is analyzed, the infinitesimal calculation is done by means of the derivative in order of the added quantity:

This is how you find the necessary increase in costs to produce more. Otherwise, it measures what is saved by reducing the quantity.

Example

For a product that is sold each at US $ 50 in the market, a company bears a different total cost as the quantity produced increases, with the machinery it has available.

For each quantity produced, the costs incurred and the billing at each level can be seen in the table below:

Amount Total Cost (US $) Total Revenue (US $) Total Profit (US $) Marginal Cost (US $) Average Cost (US $)
0 50 0 -50 - -
1 90 50 -40 40 90.00
2 120 100 -20 30 60.00
3 140 150 10 20 46.67
4 170 200 30 30 42.50
5 210 250 40 40 42.00
6 260 300 40 50 43.33
7 320 350 30 60 45.71
8 400 400 0 80 50.00

The lowest marginal cost is found in the variation of the quantity from 2 to 3 units. In this case, the increase in cost is smaller, in addition to the fact that the company starts to make a profit.

If the increase is made from 2 units to 4 units, the total cost would go from US $ 120 to US $ 170. The marginal cost is calculated as:

  • CMg = (170 – 120) ÷ (4 – 2)
  • CMg = 50 ÷ 2 = $ 25

This means that, for each of the 2 units added, the company would bear an additional cost of US $ 25 each.

Difference between marginal cost and average cost

While the marginal cost is related to the additional cost borne, the average cost is a measure of the cost per unit produced.

The average cost can be decreasing as it is calculated with larger quantities. When this happens for a company, it is said to produce at an economy of scale.

The constant increase in the average cost for larger quantities, however, is said that the company produces in scale economies. If the company wants to produce more, it will incur a higher cost per unit.

In the economy, when the average cost and the marginal cost are analyzed for the long term, it is considered that the company can change the costs of its factors of production.

In this case, it can be represented in a graph in which the marginal cost curve equals the point where the lowest average cost exists:

From the marginal cost curve, it is possible to see that, at a certain point, there will always be an increase in costs as the company produces a larger quantity.

This effect is associated with the Declining Marginal Yields Law, in which adding additional units of production factors does not increase productivity, making production more costly.

Marginal cost and marginal revenue

When analyzing the level of a production, the revenue that the product or service offers the company can be considered.

With a larger quantity, it is possible to increase revenue but also costs, given the limitations of production.

The concept of marginal revenue considers the additional income to the company with an increase in production, in an analysis similar to that of marginal cost.

In the example calculated earlier, revenue grows steadily at the price value for each quantity sold.

The marginal revenue can be seen as the added benefit of having produced one more unit. There are situations in which the marginal revenue is increasing, while the additional cost increases.

For an activity to be viable, it is possible to maximize profit to a point where the benefits and additional costs are equal.