Marginal cost is the cost of producing one additional unit. As firms produce more units, marginal costs increase until they reach a point where additional units cost almost nothing to produce.
At that point, the firm is experiencing zero marginal cost. Once production increases beyond that point, marginal cost increases as they have to pay for materials to produce additional units.
As firms in a competitive market are facing zero economic profits, they are not making any gains from the market value of their product. This is due to the fact that other firms in the market are selling similar products at the same price, thus cancelling each other out.
There is always a chance that a firm may be producing at zero marginal cost, but only if the firm is aware of this and can constantly maintain it without any problems. Otherwise, this can potentially lead to bankruptcy.
Definition of marginal cost
Marginal cost is the cost a company incurs when producing one additional unit of a product. It is the total cost to produce one more item, which includes the fixed costs and variable costs.
Fixed costs are those that do not vary with quantity produced. For example, rent and administrative salaries are fixed costs that remain the same regardless of how much product the company produces.
Variable costs are those that vary with quantity produced. These include raw material cost and labor cost. Because of this, variable costs are tied to the number of units produced.
When a firm is producing at its minimum average efficiency level (MAEL), price equals marginal cost. At this point, no additional revenue is generated by selling one more unit-it only adds additional cost. This makes sense because at this MAEL, there is no surplus capacity.
Relationship between price and marginal cost
When price is greater than marginal cost, a firm will produce at the point where additional units cost just as much as they would sell for. That is, additional units would cost the same to make as they would sell for, so there would be no loss or gain by making them.
That’s why the term “marginal” cost is used – it refers to the extra (“marginal”) cost of producing one more unit. When price is greater than marginal cost, firms will produce and sell as many units as they can at that price.
If price falls below marginal cost, then firms will begin to lose money – so they will stop producing at that point. If price rises above marginal cost, then firms will stop producing and begin to stockpile their product – which will eventually lower supply and raise price.
Graph the relationship between price and marginal cost
In order to have price be greater than marginal cost, a firm has to have a minimum level of efficiency.
If a firm has minimum efficiency, it will not be able to produce additional units of a good or service at a lower cost per unit. A low level of efficiency is when a firm has high overhead costs and/or requires more labor to produce a unit of output.
For example, if it costs a restaurant $10 to make one sandwich, then the restaurant must charge at least that much in order to break even. If the restaurant charges only $8 for the sandwich, then it will lose money on every sale.
Another way that price can be greater than MC is if there are external factors affecting the cost of production. For example, if raw materials cost $8 per unit and there are no ways to reduce that cost, then price must be greater than marginal cost by at least $8.
Example of a firm with the relationship between price and marginal cost
As mentioned before, in a competitive market, price is set at the point where a firm’s marginal cost equals the market’s price.
If a firm has sunk costs, or fixed costs, they are included in the marginal cost. If a firm did not have any fixed costs, then only variable costs would be included in marginal cost.
When a firm has high advertising costs due to many advertisements they purchase, this is a sunk cost. Because of this, the quantity of products they sell does not affect how many ads they can purchase.
If a firm produces and sells more products, their total cost per product decreases due to decreasing fixed costs. Because of this, the total cost decrease is greater than the net revenue increase, resulting in decreasing average unit cost.
Implications of the relationship between price and marginal cost
As mentioned earlier, in a competitive market, price is equal to marginal cost. Marginal cost is the cost of producing one additional unit of a good or service.
Therefore, in a competitive market, price is equal to the total average cost of all units produced. This is an important point to understand.
Businesses can gain market power by being the low-cost producer or creating products that are differentiated from their competitors’. When a business is the lowest-cost producer, they can sell their product at marginal cost and still make a profit.
If all businesses are producing at the same level of efficiency, then their prices will be the same and equal to marginal cost. This keeps prices fair and equitable for all producers and consumers.
A common misconception about capitalism is that companies want to charge high prices while maintaining low production levels. This would hurt both the company and consumers, as consumers would have to pay more for less value.
Causes of the relationship between price and marginal cost
There are two main causes of the relationship between price and marginal cost. The first is an increase in total cost due to an increase in marginal cost.
An example of this would be if oil companies bought more equipment to extract more oil, which would increase the total cost of extraction. Because they are in a competitive market, they cannot charge a higher price for their oil because their competitors will sell theirs at the same price.
The second cause is an increase in price while marginal cost remains the same. If the market for oils were to suddenly rise, then the sellers would have to raise their prices to maintain a normal profit margin.
Both of these causes show how an organization can have a higher total cost than its competitors, but cannot sell at a lower price to retain profitability.
Market structure impacts the relationship between price and marginal cost
If a firm operates in a competitive market, its price is determined by the market average for the good or service it produces.
A firm whose prices are close to the market average are considered to have uniform prices. Marginal cost is the cost to produce one additional unit of a product or service.
If a firm has low marginal costs, it can charge a higher price without losing customers due to the low cost of producing an additional unit. A firm with high marginal costs may have to lower its price in order to retain customers.
Firms with monopoly power can set their own prices, thus having non-uniform prices. These firms have very low marginal costs and can thus set very high prices without losing customers. Customers may decide to no longer purchase the product or service due to the high price, but there will still be some that purchase it at that price.
Time period impacts the relationship between price and marginal cost
As time passes, a firm’s average cost will usually increase. This is because the cost of inputs will usually increase as time passes.
For example, the cost of raw materials used to produce a good or service will usually increase over time. This is due to rising global demand and markets competing for the same supplies.
Likewise, the wages paid to workers will usually increase over time as well. This is due to rising living costs and general inflation in the economy.
Overall, this relationship between price and marginal cost is what keeps firms in check when it comes to pricing their goods and services. If price is greater than marginal cost for an extended period of time, then the firm will experience declining profitability and might go out of business.
