Marginal Cost Formula and Its Applications

Marginal cost is one of the most fundamental principles in economics, which is essential to any business’s financial analysis when evaluating the prices of goods and services. This basic principle is used in financial modelling to generate and regulate cash flow. 

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Define Marginal Cost 

The marginal cost is the additional cost incurred in producing other units of goods and services. These goods and services usually belong to the manufacturing sector of the economy. 

You can calculate the marginal cost by dividing the change in the prices by the change in quantity, resulting in the fixed costs for the items already produced. Additionally, there’s the variable cost, too, which needs to be accounted for in the manufacturing process. 

The marginal cost of production includes all the expenses that are incurred with that level of production. When the marginal cost of producing any additional items is lower than the price per unit, the manufacturer may be able to gain a profit from it. 

When you start plotting the marginal costs on a graph sheet, you will see a U-shaped curve when the prices are high. However, it shifts and starts going down as the production increases. Then, there’s a rise that happens after some point. 

How to Calculate the Marginal Cost?

Before you start calculating marginal cost, you need to understand two concepts: change in prices and change in quantity. 

• Change in Costs: There may be an increase or decrease in the prices in the production process. It is likely to happen when the manufacturing needs to increase or decrease the output volume. For example, if the production process requires two more workers to meet the output, it would change the costs. The difference in cost is calculated by subtracting the production costs in the first run from production costs in the next one. 

• Change in Quantity: In the process of production, the amount of product can increase or decrease. The quantities should be sufficient to evaluate the changes in the cost. For example, if 4000 pairs of shoes were made in the initial production run but 9000 more need to be made, you can calculate the change in the quantity by deducting the number of shoes made in the first run from the volume of the output of the next. 

Marginal Cost Formula

If you want to calculate the marginal cost of production, you need to know the marginal cost formula. The marginal cost equation is as follows:

Marginal cost =  \[ \frac {\text {Changes in costs}} {\text{Changes in Quantity}}\]

Example: 

If you look at the table below, it contains the data to calculate the marginal costs: 

Marginal cost = \[\frac{ $ 250000-225000}{3000-2000}\]

Marginal cost = \[\frac{ $ 250000-225000}{1000}\]

Marginal cost = $ 25

How to Calculate Marginal Cost 

You can use the marginal cost formula and calculate the marginal cost of production of a particular good. Here’s an example of calculating the marginal cost of production. 

ABC is a public company that manufactures 12,000 units of mattresses every year, incurring production costs of $ 4 million. However, their demand for beds increases the following year, which leads to the market in the production of more units. The increase in demand forces the management to hire more people and purchase more materials. This demand for mattresses leads to an overall production cost of $ 8 million to produce 20,000 beds. Determine the marginal cost of the production.

Marginal cost = \[ \frac{${ \text {4 million Changes in costs}}} {\text{8000 Changes in Quantity}} \] 

Marginal cost = $ 500

Long Run and Short Run Marginal Costs

Long Run Marginal Cost 

Long-run costs are incurred by a firm changing the production levels over a period of time as a response to the expected economic profits or losses. The fixed factors of production are absent in the long run. This is a stage where producers plan and implement those plans to gain profits. 

Short-Run Marginal Cost 

Short-run marginal costs are costs incurred by a firm in a short period of time. This cost can be related to a good, a service or the quantity of output produced by the firm. In the short run, the firm incurs both fixed and variable costs. The variable costs keep changing with the change in the output of the firm.

Relationship between Total Cost and Marginal Cost 

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• When the Marginal cost increases the total cost also increases at an increasing rate. This continues till the point when the marginal cost curve reaches its maximum point. 

• When the Marginal cost declines but remains positive, the total cost continues to increase but at a decreasing rate. This continues till the total cost curve reaches its maximum. 

• When the marginal cost curve is declining, while remaining positive, the total cost curve declines. 

• When the marginal cost curve becomes zero, the total cost curve reaches its maximum point. 

Relationship between Average Cost and Marginal Cost

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• When average cost falls, marginal cost is lower than average cost: 

If the average cost falls, the marginal cost is lower than the average cost. In the diagram, the average cost falls till it reaches a certain point, and the marginal cost remains less than that point. The average cost falls till point E, and the marginal cost continues to be lower than the average cost. This is why the marginal cost (MC) curve falls below the average cost (AC) curve. 

• When average cost rises, marginal cost is more significant than average cost.

When AC starts to rise, the MC is greater than AC. When average cost starts rising from point E, marginal cost is higher than average cost. 

• When average cost doesn’t change, marginal cost is equal to average cost.

If AC doesn’t change, then marginal cost = average cost. This happens when the falling average cost reaches its low point. The marginal cost curve intersects the average cost curve at its minimum point, which is E. 

What are the Benefits of Marginal Costs?

When a business conducts financial analysis, one of the best tools for calculating its marginal cost of production, here are some of the benefits of the marginal cost of production: 

• It helps in concentrating resources where excess marginal revenue over the marginal costs are at its highest. 

• Marginal costs allow for an increase and decrease in product prices, which help a company evaluate how much they will have to pay to produce more items.

• It helps companies determine how much cost advantage they can achieve through efficient production to optimise overall production in the company. 

• Marginal costs may decrease the overall cost of making a product line. 

Conclusion

Marginal cost is a very important concept in economics. It’s essential that you go through this concept thoroughly and understand it properly. When you know the concept of marginal costs, you will be able to use it as necessary in the future. Along with learning what marginal cost is, you will learn the total cost and average cost. All three concepts are easy and simple to understand.