Marginal cost
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In economics and finance, marginal cost is the change in total cost that arises when the quantity produced (or purchased) changes by one unit. Image:Marginalcost.gif Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q).
<math>MC=\frac{dTC}{dQ}</math>
A textbook distinction is made between short-run and long-run marginal cost. The former takes as unchanged the capital equipment of the producer, any change in its production involving only changes in the inputs of labour, materials and energy. The latter allows all inputs, including capital items (plant, equipment, buildings) to vary. Thus a long-run cost function describes the cost of production as a function of output assuming that all inputs are obtained at current prices, that current technology is employed everything being built new from scratch. In view of the durability of many capital items this textbook concept is less useful than one which allows for some scrapping of existing capital items or the acquisition of new capital items to be used with the existing stock of capital items acquired in the past. Long-run marginal cost then means the additional cost or the cost saving per unit of additional or reduced production, including the expenditure on additional capital goods or any saving from disposing of existing capital goods. Note that marginal cost upwards and marginal cost downwards may differ, in contrast with marginal cost according to the less useful textbook concept.
Economies of scale are said to exist when marginal cost according to the textbook concept falls as a function of output and is less than the average cost per unit. This means that the average cost of production from a larger new built-from-scratch installation falls below that from a smaller new built-from-scratch installation. Under the more useful concept, with an existing capital stock, it is necessary to distinguish those costs which vary with output from accounting costs which will also include the interest and depreciation on that existing capital stock, which may be of a different type from what can currently be acquired in past years at past prices. The concept of economies of scale then does not apply.
Marginal cost pricing is the principle of selling produced items at their marginal cost. Since the price constitutes marginal cost to the buyer, this makes marginal cost to the buyer equal to the marginal cost of production. Hence, when deciding whether or how much to buy, buyers take account of the cost to society of their actions if private and social marginal cost coincide. The equaity of price with social marginal cost, by aligning the interest of the buyer with the interest of the community as a whole is a necessary condition for economically efficient resource alocation.
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Private vs. Social Marginal Costs
Main Article: Social cost
Of great importance in the theory of marginal cost is the distinction between the marginal private and social costs. The marginal private cost shows the cost associated to the firm in question. It is the marginal private cost that is used by business decision makers in their profit maximization goals. Marginal social cost is similar to private cost in that it includes the cost functions of private enterprise but also that of society as a whole, including parties that have no direct association with the private costs of production.
Negative Externalities of Production
Image:NegativeExt.GIF Much of the time, private and social costs do not diverge from one another, but at times social costs may be either greater or less than private costs. When marginal social costs of production are greater than that of the private cost function, we see the occurrence of a negative externality of production. Productive processes that result in pollution are a textbook example of production that creates negative externalities.
Such externalities are a result of firms externalising their costs onto a third party in order to reduce their own total cost. As a result of externalising such costs we see that members of society will be negatively affected by such behaviour of the firm. In this case, we see that an increased cost of production on society creates a social cost curve that depicts a greater cost than the private cost curve.
In an equilibrium state we see that markets creating negative externalities of production will overproduce that good. As a result, the socially optimal production level would be lower than that observed. Image:PositiveExt.gif
Positive Externalities of Production
When marginal social costs of production are less than that of the private cost function, we see the occurrence of a positive externality of production. Production of public goods are a textbook example of production that create positive externalities. An example of such a public good, which creates a divergence in social and private costs, includes the production of education. It is often seen that education is a positive for any whole society, as well as a positive for those directly involved in the market.
Examining the relevant diagram we see that such production creates a social cost curve that is less than that of the private curve. In an equilibrium state we see that markets creating positive externalities of production will under produce that good. As a result, the socially optimal production level would be greater than that observed.
Other cost definitions
- Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable.
- Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the level of output, for example, labour, fuel, power and cost of raw material.
- Social costs of production are costs incurred by society, as a whole, resulting from private production.
- Average total cost is the total cost divided by the quantity of output.
- Average fixed cost is the fixed cost divided by the quantity of output.
- Average variable cost are variable costs divided by the quantity of output.
See also
fr:Coût marginal hu:Határköltség ja:限界費用 ro:Cost marginal fi:Rajakustannus zh:边际成本 pl:Koszt krańcowy