Marginal cost

Marginal cost is an economic calculation that represents the change in total cost that results from altering the quantity of output produced by a company. Specifically, marginal cost analyzes the cost of producing one extra item. Generally, a time comes when a company can earn revenue by producing an additional item, as this will lower the total cost. Therefore, marginal cost is often used to find a company’s most favorable production level and to keep manufacturing costs low. Marginal cost involves the law of diminishing marginal returns. It can be represented graphically by a curve called the marginal cost curve. To calculate marginal cost, two different equations can be used. Examining the way in which a company analyzes marginal cost can provide a better understanding of the concept.

Overview

Marginal cost is used to analyze short-run production. The concept represents the change in the total cost of a production run. It includes variable costs, such as labor and materials, and  estimated fixed costs, such as administrative expenses. Marginal cost is an important concept for businesses seeking to analyze their production.

Once the breakeven point is achieved, marginal cost can be calculated. The breakeven point is the moment when the projected revenue is equal to the estimated total cost. It is also the moment when profits begins to grow.

Law of Diminishing Marginal Returns

An increase in marginal cost points to the law of diminishing marginal returns. This law states that as a company’s workers increase in number and the other aspects of production remain the same, each additional worker will eventually produce less output. In other words, at some point, each additional worker will hamper the company’s production and return.

Marginal Cost Curve

The marginal cost curve is a graphical representation of the relationship between the quantity of production and the marginal cost. This U-shaped curve features a downward slope that represents small quantities of production. The curve then hits a minimum value. Lastly, it curves upward to represent large quantities of production. This means that marginal returns increase and then decrease. Furthermore, marginal cost decreases as marginal returns increase and vice versa.

Marginal Cost Equations

To calculate marginal cost, one of two equations can be used. For the first equation, divide the change in total cost by the change in quantity of output. An equation using total variable cost can also be applied because the change in total cost is the same as the change in total variable cost. For this equation, divide the change in total variable cost by the change in quantity of output.

Practical Example of Marginal Cost

Marginal cost can be better understood by examining a specific production run. Consider a company that produces lamps. To calculate the marginal cost, the company must analyze its production. The company will examine the different quantities of lamps produced, the total variable cost of producing each quantity, and the total cost of producing each quantity. The quantities range from zero to ten.

At a quantity of zero, the total variable cost is $0, and the total cost is $5. When the first lamp is produced, the total variable cost is $9, and the total cost is $14. The total variable cost increases from $0 to $9, and the total cost increases from $5 to $14. This means that the marginal cost of producing the first lamp is $9. If the quantity of lamps is increased to two, the total variable cost is $15, and the total cost is $20. The total variable cost changes from $9 to $15, and the total cost changes from $14 to $20. This creates a marginal cost of $6 for producing the second lamp. When a third lamp is produced, the total variable cost is $19, and the total cost is $24. The total variable cost increases from $15 to $19, and the total cost increases from $20 to $24. Therefore, the marginal cost of producing the third lamp is $4. The company continues to calculate the marginal costs in this way. The following list presents all of the marginal costs:

• Quantity of 0: $5
• Quantity of 1: $9
• Quantity of 2: $6
• Quantity of 3: $4
• Quantity of 4: $3
• Quantity of 5: $3
• Quantity of 6: $4
• Quantity of 7: $6
• Quantity of 8: $9
• Quantity of 9: $13
• Quantity of 10: $19

An analysis of this data reveals several important points. The marginal cost of producing the first lamp is rather high at $9. The marginal cost then declines, eventually reaching a low of $3. It then rises again until it reaches a high of $19. The drop in marginal cost is related to Stage I of production and to the increase in marginal returns. The rise in marginal cost is related to Stage II of production. Furthermore, it is related to the decrease in marginal returns and the law of diminishing marginal returns. Additionally, the marginal cost stays on the positive side and does not drop into the negative or even hit zero. A negative marginal cost is possible only if a decrease in total cost occurs. This simply does not happen in business.

In many digital markets, the marginal cost of distributing an additional copy of a digital good (such as software or streaming content) can be very low relative to upfront fixed costs, affecting pricing strategies and competitive dynamics. In cloud computing and software-as-a-service (SaaS), firms increasingly track the marginal cost of serving an additional user or workload as part of operational cost management.

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