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What Is the Relationship between Marginal Cost and Supply?

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  • Written By: B. Turner
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  • Last Modified Date: 22 September 2016
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In economics, marginal cost is the additional cost associated with producing one extra unit of a product. Businesses rely on this information to help them make decisions related to pricing and production goals. In a purely competitive market, marginal cost and supply will always be equal. Graphically, these can both can be illustrated by the same positively-sloped cost curve, and will overlay one another at every price point. In a market that is less than perfectly competitive, however, the relationship between marginal cost and supply changes and the two values are no longer equal.

As price levels increase, the quantity of goods and services that businesses produce will also increase. For example, a firm that makes cars will sell a certain number of units at one price, but if the market price goes up, the firm will make more cars in order to maximize profit. The inverse is also true, resulting in decreased production as market prices go down.

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This same type of relationship can also be seen when examining marginal cost, though for different reasons. The law of diminishing returns states that as firms increase resources needed to ramp up production, marginal cost will decline, bottom out, then start to rise. To understand why, consider a car factory with 100 workers. Adding 25 more workers can help increase production and bring down the marginal cost of each new car. If the firm were to add another 100 workers, however, these employees would start to slow each other down, or get in each other's way, resulting in an increase in marginal cost.

From this example, one can see that as supply rises, price will also increase automatically. In a perfectly competitive market, firms will set production rates at the exact point where price equals marginal cost. By doing so, they are able to maximum profits and efficiency. Given that price is constantly fluctuating due to natural market forces, production rates, or supply, will continuously change as well. This relationship between marginal cost and supply holds at every price point, and continues to hold as price fluctuates.

In a market that it not perfectly competitive, this relationship between marginal cost and supply no longer holds true. For example, a firm that has a monopoly over the market does not have to respond to price changes because he is able to set prices for a product. In this type of market, the company determines production rates based on demand rather than marginal cost.

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donasmrs
Post 3

The law of diminishing returns has a lot to do with the relationship between marginal cost and supply like the article said. It's because of this law that marginal cost increases as supply increases.

Aside from the assumption that there is perfect competition here, there is also the assumption that all firms want to maximize their profits. Maximum profit made when marginal cost is equal to price. S as prices go up, so does marginal cost and supply.

candyquilt
Post 2

@anamur-- I'm not very good with economy, I'm sure someone else can answer this better. From what I understand, marginal cost and supply is the same thing.

When I have to figure out supply for a price or demand, I find out by looking at the marginal cost curve for a firm's graph. This is of course, when there is perfect competition.

In the real world, we don't usually have perfect competition, so we can't take this graph and apply it directly to real life. But we can make comparisons between this "perfect picture" and reality to see what supply should be or what the marginal cost is.

serenesurface
Post 1

When supply rises, doesn't competition increase, leading to higher prices? And higher prices will eventually decrease demand and increase marginal cost?

I don't see how marginal cost increases as supply increases.

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