What is Marginal Cost?

1 Apr 2021  Read 867 Views

Do you know how a company decides the quantity of output it should produce? No? Well, the answer is marginal cost. In this article, let's understand what marginal cost is. And why is it essential for a company?

Definition

The marginal cost of production is the additional cost incurred to produce an additional unit of output. It is calculated by dividing the change in total production cost by the change in quantity. It helps in determining the optimal production level and helps in achieving economies of scale. If the marginal cost of the product is less than the selling price of the last unit sold, then the producer is encouraged to produce more to maximize his profits.

There are two types of marginal cost based on the time: Short Run Marginal Cost and Long Run Marginal Cost. As the name suggests, Short-Run Marginal Cost is the marginal cost in the short run. In the short run, there are fixed factors of production like land, building, machinery, etc. They cannot be altered. So, only variable cost changes, which becomes the marginal cost.

In the long run, there are no fixed factors of production. So, there will be variable costs only. It will be considered for calculating the marginal cost.

Computation of Marginal Cost

There are two types of costs that a company has to incur: Fixed and Variable Costs. Fixed costs remain constant, irrespective of the level of output produced. The best example is the factory rent. Many landlords aren't that generous to reduce the rent if fewer units are produced. Similarly, he can't charge more rent in case of more production.

Variable costs vary with the level of output. The best example is material cost. For each unit, raw materials are required. As mentioned above, fixed costs remain constant. But total variable costs increase with an increase in output. That is why the variable cost of producing the product is its marginal cost.

Let's understand it with an example:

Assume that in a factory, plastics are required to produce a pen. If the plastic required costs Rs. 5 per unit, it is a variable cost. Therefore, the marginal cost is Rs. 5.

But the factory will have a production limit (assume 1000 in this case). And the monthly rent is Rs 1 Lakh. For producing 1001 pens, a new factory is required. So, the rent will also be considered in the marginal cost. (P.S. Don't worry, we won't show you the complex calculations. It was only to make you understand the concept.) 

Importance of Marginal Cost

Those of you who have studied economics in class 11 would know all of this. Those who are from a science background, don't worry. You will understand this effortlessly.  

The marginal cost of production is an essential tool in economics and managerial accounting. It is used by the producers to determine the optimal level of output to be produced. 

Producers will produce to a level where the marginal cost is equal to the marginal revenue (i.e., additional revenue earned from selling an additional unit of output). If marginal cost is less than marginal revenue, production of additional units will result in net profit. So, the producer will increase the level of output to earn more profits.

If the marginal cost exceeds marginal revenue, the production of additional units will lead to net loss. So, the producer will reduce production to earn profits.

When marginal cost is equal to marginal revenue, the producer will be in equilibrium and maximize profits. He will earn lesser profits, whether he produces more or less than this point. So, the optimal production level will be determined by comparing the marginal cost and marginal revenue.

Let's understand it with an example. The following is a schedule showing the marginal cost and marginal revenue at different levels of output.

Units produced

Marginal Cost (MC)

Marginal Revenue (MR)

Total Cost (TC=∑MC)

Total Revenue (TR=∑MR)

Total Profit

(TR – TC)

1

5

8

5

8

3

2

7

8

12

16

4

3

8

8

20

24

4

4

10

8

30

32

2

Here,

  • If the producer produces 1 or 2 units, marginal cost is less than marginal revenue. So, he will produce more to earn more profits.
  • If he produces four units, marginal costs exceed marginal revenue. So, he will produce less output to increase profits.

Therefore, he will produce three units, where marginal cost equals marginal revenue. Here, he will earn maximum profits.

Zero Marginal Cost Economics

Yes, you guessed it right. Zero marginal cost economics is the study to minimize the cost of producing an additional unit to such an extent that it becomes close to zero.

Previously, we read that a producer produces until the marginal cost is equal to marginal revenue. But today is the era of technology, which has made it possible to make the marginal cost zero. It doesn't mean that there will be no production. It is just that the additional cost of production will be eliminated. 

The best example is the OTT model. Think what is the Cost to Netflix when an additional person subscribes. It will be zero. Netflix won't feature a show just for you, will it? You can only watch the available shows, which is the same for every subscriber. 

Anyways, this model will disrupt the existing economics. It will help in achieving economies of scale, which will result in lower prices for consumers. We can buy a 1-month OTT subscription for the entire family at the cost of 1 ticket.

It can be applied in different industries. The marginal cost of energy can be made zero by using renewable energy. The use of social media has eliminated the cost of physical marketing. With the introduction of EdTech companies like Udemy, there are massive open online courses (MOOCs) that may replace physical education in the future!    

Conclusion

Marginal cost is the cost to produce an additional unit of output. It helps in knowing the units a firm should produce to maximize profits and achieve economies of scale. It is different in the short run and long run. In both cases, it is the variable cost incurred. Zero marginal cost economics is the way to make the marginal cost zero. It can be achieved by leveraging the use of technology, which will help in economies of scale. It is being used in many industries. 

In the end, remember that cost and profit are inversely related. So, try to minimize the cost to maximize the returns.

About the Author: Prasuk Jain | 30 Post(s)

Prasuk is an inquisitive and tenacious person with a mix of enthusiasm and a positive attitude, currently pursuing CA. 

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