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What is Marginal Cost?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 14 September 2016
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Marginal cost is the cost incurred to produce one more unit of a good. If a company makes 101 things instead of 100, for example, the cost of producing the 101st item is the marginal cost. This cost can vary considerably, and it is one of the things which is balanced when deciding what to produce and how much of it to produce. Many companies aim for equilibrium, with the cost and the benefits being balanced, although there may be cases in which higher costs or lower benefits are considered acceptable, given the available information.

One might think that the cost of producing one more item remains fixed, but that is not actually the case. Marginal cost tends to follow a curve. When producing a limited number of items, itis generally high, while production in larger numbers brings about a drop in cost. Making decisions about production involves finding the sweet spot where marginal costs dovetail with the benefits.

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One way to think about it is to imagine a construction firm which builds houses. If it builds five houses a year, the marginal cost will be high to build a sixth house, while if it builds 10 houses, the cost to build an 11th house may drop because the company can negotiate lower prices for raw materials and it develops an efficient construction system. When the number climbs to 15, however, the costs of administration start to add up, pushing the cost up again when the company goes to make a 16th house.

The raw cost of production is part of this cost, which includes things like materials, energy needed to produce the item, the factory the item is produced in, and so forth. Other things which contribute to this cost include things like administration costs and the limitations of technology and resources. A company's marginal costs can climb as it starts to push these limits. Likewise, externalities such as the environmental impact of the product may also be computed as part of the marginal cost.

There are some cases in which marginal cost may be allowed to get quite high in the interests of receiving improved benefits. Pollution control is a classic example. The cost of basic measures is generally low, and considered acceptable. As these measures are exhausted and people have to work harder to control pollution, the cost starts to climb. This is not economically efficient, but it is deemed a reasonable cost in the interests of keeping pollution low so that people and the environment stay healthier.

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