Question: How are Marginal Cost Functions used for taking buy or sell decisions?

Solution:

Marginal cost is the additional cost incurred for the production of an additional unit of
output. However, because fixed costs do not change based on the number of products
produced, the marginal cost is influenced only by the variations in the variable costs.

MC is particularly important in the business decision-making process.

Formula:

Marginal Cost = Change in Total Cost / Change in product output

Here, Southern Company is the nation’s third-largest Electric Utility firm. The company uses
a computerized and automated method to generate and dispatch electricity to its
customers. This automated Load dispatching method is also known as the “Early Bird”
system.

The “Early Bird” continuously calculates the marginal cost of delivering additional Kilowatts
of electricity to its customers anywhere in the company service area. As mentioned above
Marginal cost can be understood as the change in total cost that arises when the quantity
produced (power in this case) changes by one unit.

Sothern Company has several power generating units. Each unit is tested to see how much
fuel labour and other variable inputs are required to generate electricity. In this way, a
continuous production function can be created. This information is then fed to the early
bird; so combined with the production function along with the price of input variables one
can calculate the marginal cost for a particular unit at whatever rate it is operating.

Now if electricity demand increases then the “Early Bird” generates more electricity, the
“Early Bird” is programmed to compare the marginal cost of producing electricity in all its
units. The unit with the lowest Marginal Cost is then used to generate electricity.
Additionally, Southern’s power system control centre is equipped to forecast short term
loads, thus the cost of producing electricity to power this short term load can be estimated
in advance. This estimated Marginal cost is then compared with the estimated marginal cost
of adjacent electric companies or firms.
If the Marginal cost of producing the same block of electricity by Sothern Company is more
costly than the other firms, then the Sothern Company finds it more economical to buy
electricity from adjacent firms.

However, if the Marginal cost of producing the same block of electricity by Southern
Company is less than those of its neighbours, then it may agree to sell a block.

Please refer below the summary:

1. P charged of each extra power unit generated > Marginal Cost, then Sell block of unit
2. P charged of each extra power unit generated < Marginal Cost, then Buy less MC
block from neighbours.

To maximize profits or to minimize losses. The easiest way of determining the point at which
profits are maximized is to compare total revenue and total costs or to equal marginal
revenue (MR) and marginal cost (MC). This rationale is shown in Figure below. The firm
maximizes profit by selling a quantity (Q) for which MC = P.

The vertical distance between the total revenue line and the total cost curve indicates the
profit. It will be maximum when Q is the number of units produced. The firm's profit
function is derived by subtracting TC from TR at each rate of output. In this system, it is also
possible to incur losses in the short run and still continue producing, depending on the level
of prices in the market and when this alternative will mean fewer losses than shutting down
production entirely.

The graph shows the case that a firm is facing by lower and lower P. Whether the firm
realizes a profit or a loss depends on the relationship between price and average total cost
at the intersection of MR and MC.
The quantities to produce (Qd, Qc, Qb and Qa) for each different level of prices (Pd, Pc ,
Pb and Pa) are determined as: Price = Marginal Cost

 The point (Qd, Pd) maximizes profit due to price Pd exceeds ATC.
 The point (Qc, Pc ) a break-even point, profit equals zero. The price Pc, equals
ATC.
 The point (Qb, Pb) minimizes its short-term losses due to price Pb is less than ATC
but higher than AW. So, the TFC are paid and the TVC are partially recovered.
 The point (Qa,Pa) is a shutdown point, negative profit equals TFC or Pa = AVC.
 Short-run losses equal to TFC will be incurred if production is temporarily ceased.

Conclusion:

Marginal cost is useful for taking the decision of buy or sell as shown above at various points
when the profit is maximum and when is the short run losses (they should buy from outside
instead of producing more).