What Is the Relationship between Marginal Cost and Supply?

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.

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.