Marginal Cost

Definition

Marginal cost refers to the additional cost incurred by a firm to produce one more unit of a good or service. It represents the change in total cost that results from increasing output by one unit, holding all other factors constant.

5 Must Know Facts For Your Next Test

1. Marginal cost is a crucial concept in microeconomics and plays a central role in a firm's output decisions.
2. In the short run, as output increases, marginal cost typically rises due to the law of diminishing returns, where additional inputs become less productive.
3. In perfectly competitive markets, firms maximize profit by producing the quantity where marginal cost equals marginal revenue.
4. Marginal cost is also an important factor in determining the efficiency of resource allocation in perfectly competitive markets.
5. Monopolies, on the other hand, set output and price where marginal revenue equals marginal cost to maximize profits.

Review Questions

• Explain how marginal cost relates to a firm's output decisions in a perfectly competitive market.
  • In a perfectly competitive market, a firm will maximize its profits by producing the quantity where its marginal cost equals its marginal revenue. This is because the firm is a price-taker, so it can sell an additional unit at the market price. By producing up to the point where marginal cost equals marginal revenue, the firm ensures that the additional revenue from selling one more unit just covers the additional cost of producing that unit, thereby maximizing its overall profit.
• Describe the relationship between marginal cost and the efficiency of resource allocation in perfectly competitive markets.
  • In a perfectly competitive market, the equilibrium price and quantity are determined by the intersection of the market demand and supply curves. At this equilibrium, the marginal cost of producing the last unit equals the marginal benefit to consumers, as reflected in the market price. This ensures that resources are allocated efficiently, as no further gains can be achieved by reallocating resources. If marginal cost diverged from the market price, it would indicate a misallocation of resources and potential for welfare improvements through increased or decreased production.
• Analyze how a profit-maximizing monopoly uses marginal cost to determine its output and price decisions.
  • A profit-maximizing monopoly will choose the output level where its marginal revenue equals its marginal cost. This is because the monopolist faces a downward-sloping demand curve, so increasing output will lower the price it can charge for each unit. By producing up to the point where marginal revenue equals marginal cost, the monopolist ensures that the additional revenue from selling one more unit just covers the additional cost of producing that unit, thereby maximizing its overall profit. However, this output level is typically lower and the price higher than what would occur in a perfectly competitive market, resulting in a deadweight loss and less efficient resource allocation.

Related terms

Total Cost:

The total amount of money a firm must spend to produce a given quantity of output, including both fixed and variable costs.

Variable Cost: Costs that vary directly with the level of output, such as raw materials, labor, and energy expenses.

Fixed Cost: Costs that do not change with the level of output, such as rent, insurance, and administrative expenses.