Marginal Cost

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Marginal cost
In economics, the marginal cost is the change in the total cost that
arises when the quantity produced is incremented, the cost of
producing additional quantity.[1] In some contexts, it refers to an
increment of one unit of output, and in others it refers to the rate of
change of total cost as output is increased by an infinitesimal
amount. As Figure 1 shows, the marginal cost is measured in
dollars per unit, whereas total cost is in dollars, and the marginal
cost is the slope of the total cost, the rate at which it increases with
output. Marginal cost is different from average cost, which is the
total cost divided by the number of units produced.

At each level of production and time period being considered,

marginal cost include all costs that vary with the level of
production, whereas costs that do not vary with production are
fixed. For example, the marginal cost of producing an automobile
will include the costs of labor and parts needed for the additional Figure 1: Marginal and Total Cost of
automobile but not the fixed cost of the factory building that do not Production
change with output. The marginal cost can be either short-run or
long-run marginal cost, depending on what costs vary with output,
since in the long run even building size is chosen to fit the desired output.

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 :[2]

If the cost function is not differentiable, the marginal cost can be expressed as follows:

where denotes an incremental change of one unit.

Contents
Short run marginal cost
Long run marginal cost
Cost functions and relationship to average cost
Empirical data on marginal cost
Economies of scale
Perfectly competitive supply curve
Decisions taken based on marginal costs
Relationship to fixed costs
Private versus social marginal cost
Negative externalities of production
Positive externalities of production
Relationship between marginal cost and average total cost
Profit maximization
See also
References
External links

Short run marginal cost

Short run marginal cost is the change in total cost when an
additional output is produced in the short run and some costs are
fixed. In the on the right side of the page, the short-run marginal
cost forms a U-shape, with quantity on the x-axis and cost per unit
on the y-axis.

On the short run, the firm has some costs that are fixed
independently of the quantity of output (e.g. buildings, machinery).
Other costs such as labor and materials vary with output, and thus
Short Run Marginal Cost
show up in marginal cost. The marginal cost may first decline, as
in the diagram, if the additional cost per unit is high if the firm
operates at too low a level of output, or it may start flat or rise
immediately. At some point, the marginal cost rises as increases in the variable inputs such as labor put
increasing pressure on the fixed assets such as the size of the building. In the long run, the firm would
increase its fixed assets to correspond to the desired output; the short run is defined as the period in which
those assets cannot be changed.

Long run marginal cost

The long run is defined as the length of time in which no input is
fixed. Everything, including building size and machinery, can be
chosen optimally for the quantity of output that is desired. As a
result, even if short-run marginal cost rises because of capacity
constraints, long-run marginal cost can be constant. Or, there may
be increasing or decreasing returns to scale if technological or
management productivity changes with the quantity. Or, there may
be both, as in the diagram at the right, in which the marginal cost
first falls (increasing returns to scale) and then rises (decreasing Long Run Marginal Cost
returns to scale).[3]

Cost functions and relationship to average cost

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.[4] 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.[5] 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.[6] 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

Empirical data on marginal cost

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.[7] 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.[8]: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[8]

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.[7]

Economies of scale
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.[9] 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).

Perfectly competitive supply curve

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.

Decisions taken based on marginal costs

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.[10]

Relationship to fixed costs

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.

Private versus social marginal cost

Of great importance in the theory of marginal cost is the distinction between the marginal private and social
costs. The marginal private cost shows the cost borne by the firm in question. It is the marginal private cost
that is used by business decision makers in their profit maximization behavior. Marginal social cost is
similar to private cost in that it includes the cost of private enterprise but also any other cost (or offsetting
benefit) to parties having no direct association with purchase or sale of the product. It incorporates all
negative and positive externalities, of both production and consumption. Examples include a social cost
from air pollution affecting third parties and a social benefit from flu shots protecting others from infection.

Externalities are costs (or benefits) that are not borne by the parties to the economic transaction. A producer
may, for example, pollute the environment, and others may bear those costs. A consumer may consume a
good which produces benefits for society, such as education; because the individual does not receive all of
the benefits, he may consume less than efficiency would suggest. Alternatively, an individual may be a
smoker or alcoholic and impose costs on others. In these cases, production or consumption of the good in
question may differ from the optimum level.

Negative externalities of production

Much of the time, private and social costs do not diverge from one
another, but at times social costs may be either greater or less than
private costs. When the marginal social cost of production is
greater than that of the private cost function, there is a negative
externality of production. Productive processes that result in
pollution or other environmental waste are textbook examples of
production that creates negative externalities.

Such externalities are a result of firms externalizing their costs onto

a third party in order to reduce their own total cost. As a result of Negative Externalities of Production
externalizing such costs, we see that members of society who are
not included in the firm will be negatively affected by such
behavior of the firm. In this case, an increased cost of production in society creates a social cost curve that
depicts a greater cost than the private cost curve.
In an equilibrium state, markets creating negative externalities of production will overproduce that good. As
a result, the socially optimal production level would be lower than that observed.

Positive externalities of production

When the marginal social cost of production is less than that of the
private cost function, there is a positive externality of production.
Production of public goods is a textbook example of production
that creates positive externalities. An example of such a public
good, which creates a divergence in social and private costs, is the
production of education. It is often seen that education is a positive
for any whole society, as well as a positive for those directly
involved in the market.

Such production creates a social cost curve that is below the Positive Externalities of Production
private cost curve. In an equilibrium state, markets creating
positive externalities of production will underproduce their good.
As a result, the socially optimal production level would be greater than that observed.

Relationship between marginal cost and average total 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 Relationship between marginal cost
bend the average cost curve downwards and if the marginal cost is and average total cost
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).

Average cost
Profit maximization
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).

See also
Average cost
Break even analysis
Cost
Cost curve
Cost-Volume-Profit Analysis
Cost-sharing mechanism
Economic surplus
Marginal concepts
Marginal factor cost
Marginal product of labor Profit Maximizing Graph
Marginal revenue
Merit goods

References
1. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action (https://archiv
e.org/details/economicsprincip00osul). Upper Saddle River, NJ: Pearson Prentice Hall.
p. 111 (https://archive.org/details/economicsprincip00osul/page/n127). ISBN 0-13-063085-3.
2. Simon, Carl; Blume, Lawrence (1994). Mathematics for Economists. W. W. Norton &
Company. ISBN 0393957330.
3. The classic reference is Jakob Viner, "Cost Curves and Supply Curve," Zeitschrift fur
Nationalokonomie, 3:23-46 (1932).
4. Silberberg & Suen, The Structure of Economics, A Mathematical Analysis 3rd ed. (McGraw-
Hill 2001) at 181.
5. See http://ocw.mit.edu/courses/economics/14-01-principles-of-microeconomics-fall-
2007/lecture-notes/14_01_lec13.pdf.
6. Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded
on [12 Sept 2009].
7. Lavoie, Marc (2014). Post-Keynesian Economics: New Foundations (https://books.google.co
m/books?id=bv72AwAAQBAJ). Northampton, MA: Edward Elgar Publishing, Inc. p. 151.
ISBN 978-1-84720-483-7.
 8. Blinder, Alan S.; Canetti, Elie R. D.; Lebow, David E.; Rudd, Jeremy B. (1998). Asking About
Prices: A New Approach to Understanding Price Stickiness (https://books.google.com/book
s?id=6OOFAwAAQBAJ). New York: Russell Sage Foundation. ISBN 0-87154-121-1.
9. Vickrey W. (2008) "Marginal and Average Cost Pricing". In: Palgrave Macmillan (eds) The
New Palgrave Dictionary of Economics. Palgrave Macmillan, London
10. "Piana V. (2011), Refusal to sell – a key concept in Economics and Management,
Economics Web Institute." (http://www.economicswebinstitute.org/glossary/refusaltosell.htm)

External links
Bio, Full (2021-05-19). "Marginal Cost Of Production Definition" (https://www.investopedia.c
om/terms/m/marginalcostofproduction.asp). Investopedia. Retrieved 2021-05-28.
Nwokoye, Ebele Stella; Ilechukwu, Nneamaka (2018-08-06). "(PDF) CHAPTER FIVE
THEORY OF COSTS" (https://www.researchgate.net/publication/326841533_CHAPTER_FI
VE_THEORY_OF_COSTS). ResearchGate. Retrieved 2021-05-28.
"Theory and Applications of Microeconomics - Table of Contents" (https://2012books.lardbuc
ket.org/books/theory-and-applications-of-microeconomics/). 2012 Book Archive. 2012-12-29.
Retrieved 2021-05-28.

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