What is Marginal Cost of Production?

The marginal cost of production is kind of like the extra money it would take to buy a new robotic arm…

Let’s say you own a factory that makes comfy office chairs. When you first started producing the chairs, you were only making a few, and your trusty robot Timmy could handle the load. But now that business is booming and the demand for your chairs has increased, Timmy is overwhelmed with the extra work to make the greater quantity. To produce more chairs, you have to buy a new, more advanced robotic arm that can manage the work. This increased cost to make more chairs is like the marginal cost of production.

The marginal cost of production is meant to capture all costs that change as production levels change. That could include the raw materials, direct labor, increased utility costs, and even the opportunity cost of the time, money, equipment, and effort that goes into making more products.

Marginal cost does not include things that stay the same in the short-run, regardless of how much you produce. These are called fixed costs. Things like lease payments, insurance, marketing, indirect labor, and management salaries are not included in marginal costs.

To calculate marginal cost, you divide the change in cost by the change in production using the following formula:

Marginal cost = (new cost – previous cost) / (new production – previous production)

Technically, the marginal cost should be calculated on each unit of production — aka the instantaneous rate of change. However, it’s not always feasible or necessary to do calculus. Instead, companies can get a close approximation by looking at how costs and production levels change between two different points.

For example, if one day a business records a cost of $15,000 to produce 1,000 units, then records a total cost of $35,000 to produce 2,000 units on another day, you can calculate the marginal cost of production on that second 1,000 units.

Marginal cost = ($35,000 – $15,000) / (2,000 – 1,000) = $20,000 / 1,000 = $20 per unit

In this case, the marginal cost of production increases to $20 per unit. The problem with marginal cost calculations is that the answer can be misleading when you use data that’s too far apart.

For instance, let’s do the calculation between zero units and 2,000 units rather than just the second batch of 1,000 units as we did before:

Marginal cost = ($35,000 – $0) / (2,000 – 0) = $35,000 / 2,000 = $17.50 per unit

By approximating the marginal cost over more units, you lose insight into how each unit cost is changing. Losing that insight can lead to poorer decision making and lost profits for companies.

Consider the case in which you sell each unit for $18. Using the average cost across both batches would lead you to make 2,000 units ⁠— Since the $18 in revenue is more than the $17.50 cost.

So, you end up with $36,000 in revenue, minus $35,000 in costs, and you feel good about that $1,000 in profits. In reality, though, the marginal cost of production on the second batch was actually $20 per unit.

Since you only collected $18 in revenue but spent $20 in costs, you lost money on those 1,000 units. It would have been more profitable to make and sell 1,000 units rather than 2,000.

While marginal cost tracks the change in cost compared to production, average cost is the total cost divided by total production. In other words, the average cost looks at the big picture by including fixed costs.

Average variable costs tend to increase with production. Together, the average total cost is U-shaped — The gains in spreading fixed costs are overcome by increasing marginal costs. If the marginal cost is below the average cost, the business can take advantage of economies of scale by increasing its level of output.

The term marginal benefit is intended to capture all of the positive attributes of a decision. In business, the marginal benefit usually means the additional revenue that’s generated from selling one more item. In public policy, it might be a measure of a wide range of value metrics — including things like job creation and improved public health.

For an individual, the marginal benefit of a choice is not usually monetary. It could include emotional benefits, enjoyment, and personal satisfaction. Marginal costs, on the other hand, capture the negative attributes of a decision. In business, this is usually the direct cost of an incremental unit of production. In public policy, this could include the economic loss stemming from increasing taxation, the displacement of people in cases of eminent domain, or the loss of social benefit related to stopping a program.

For an individual, marginal costs include the monetary cost of a purchase and any displeasure associated with a decision. For example, a marginal cost of cooking dinner could include the dissatisfaction of having to wash the dishes.

Comparing these costs and benefits is called marginal analysis. Any circumstance in which the marginal benefits outweigh the marginal costs will result in an improvement. The most common use of marginal analysis is in business — A positive result from a marginal analysis will increase profits.

A well-conducted marginal analysis discards any costs and benefits not directly related to the decision at hand. For example, the decision of whether or not to expand production shouldn’t consider how much you paid for the building because that expense already occurred based on prior choices. When these external and unrelated past costs enter the equation to justify a decision, it’s called a sunk cost fallacy.

Marginal cost is the rise in total costs as production increases. Likewise, marginal revenue is the amount that a company’s total revenue increases for each additional unit produced.

While the marginal cost of production defines the supply curve, marginal revenue doesn’t define the demand curve, with one exception — in the case of perfect price discrimination (aka the ability to charge each individual the most they are willing to pay for a product).

Marginal revenue is a special case of marginal benefits, which only considers the payments received for ramping up production levels. However, the marginal revenue of an additional unit of production is not simply the payment you receive for it because of the law of demand.

When a business prices a product, customers then decide if they’re willing to make that purchase or not. In order to boost sales, the business may also consider reducing the price of all units.

While there’s an increase in revenue from new customers, that’s offset by lost revenues from existing customers who were willing to pay a higher price. An optimal pricing strategy considers this by setting a marginal cost and marginal revenue equal to one another.

Although competition prevents optimal pricing strategy from being that easy, the business will see an increase in profits any time the marginal revenue exceeds the marginal cost of production.

Simply put, the marginal cost curve defines the supply curve. The law of supply states that the next unit of production will tend to cost more than the previous unit. That happens because businesses generally exhaust their best options first. Consequently, the next best option will cost more to use. The cost of that incremental unit is the marginal cost of production.

If you were to plot the quantity of production on one axis and the marginal cost of production on the other, you end up with the supply curve — the relationship between production costs and quantity. Collectively, this relationship is called the supply of the product. It informs you how the costs of production will change as production levels change.

Moving along the supply curve describes how marginal costs change within the existing supply. These changes in quantity and price don’t change the overall supply curve of a product. They just move production along it from one point to the next.

But, if an underlying cost of production changes across all units of production (such as the minimum wage increasing), then you have a change in overall supply, which shifts the entire supply curve either right or left.