In microeconomics marginal costs (MC) can be defined as the expenses connected with producing an additional unit of the product (goods or services). Classic definition presents MC as the sum of all extra costs which a manufacturing company has to cover in order to produce the next (or additional) unit of the product. Mathematically, MC can be found as a derivative of total costs (TC) function in respect to unit quantity (Q) function. At that, TC is the sum of fixed production cost (FC) and variable cost (VC).
It is possible to exemplify the concept of MC with the following simple model. A company produces some goods and spends $50 a day for renting the premises, equipment and producing plant (FC). VC (wages, raw materials, energy, etc.) for producing the first five units are $40, 35, 30, 25 and 30 respectively. Therefore, MC for producing every additional unit is $35 for the 2nd one, $30 for the 3rd, $25 for the 4th and $30 for the 5th ones, as it is presented in the following table:
(3) + (4)
? (5) ? ? (Q)
Since in this example ?Q = 1, MC for every unit is equal to the change of TC, which is actual VC. But certainly in serious business studies such situation occurs rarely, because it can be necessary to calculate MC for a set or a number of additional units. Moreover, this example must be considered in terms of a short run, when FC does not change. But in a long run FC can change (for example, in case if new buildings are bought for producing additional units), therefore MC will not be related to VC so very obviously.
In other words, on every production level and period of time, MC includes all the costs which vary with any changes in production volumes. Money/output relationship of MC is presented in the picture below. It is possible to see that in the beginning the line gradually decreases, but then it radically increases. This phenomenon can be explained by the law of diminishing returns, according to which VC firstly grow slightly, and then at some point start growing increasingly.
Specialists underline that the concept of MC is a very important strategic tool for any manufacturing company. First of all, it helps to calculate an optimum production level. One of the key principles of microeconomics states that it is rational to increase manufacturing volumes and sell additional units of product, until MC of the last produced unit will be smaller than its market price. Besides, using this concept is a great opportunity for a company to learn about the dynamic of this type of costs, which can be easily controlled.