Marginal Cost

Definition

Marginal cost is the additional cost incurred by a firm when producing one more unit of a good or service. It represents the change in total cost that results from a small increase in output. Marginal cost is a crucial concept in understanding a firm's production decisions and profitability across various market structures.

5 Must Know Facts For Your Next Test

1. Marginal cost is a key determinant of a firm's profit-maximizing output level in both perfect competition and monopoly markets.
2. In the long run, a firm's marginal cost curve is U-shaped, reflecting the principle of diminishing marginal returns.
3. Firms will continue to produce as long as the market price is greater than or equal to their marginal cost.
4. Marginal cost is a crucial input for a firm's entry and exit decisions in the long run, as it determines whether production is profitable.
5. Policymakers often use marginal cost analysis to assess the efficiency of markets and the impact of regulations or taxes on firm behavior.

Review Questions

• Explain how marginal cost is related to a firm's production decisions in a perfectly competitive market.
  • In a perfectly competitive market, a firm will maximize profits by producing the quantity where its marginal cost is equal to the market price. This is because the firm is a price-taker, so it can sell an additional unit at the prevailing market price. As long as the market price is greater than or equal to the firm's marginal cost, it will continue to produce more output. The firm will stop producing when the market price falls below its marginal cost, as any additional units would result in a loss.
• Describe how marginal cost influences a firm's entry and exit decisions in the long run.
  • In the long run, a firm will enter a market if the market price is greater than or equal to its long-run marginal cost. This ensures the firm can cover all of its costs, including the opportunity cost of its fixed inputs. Conversely, a firm will exit a market if the market price falls below its long-run marginal cost, as continued production would result in economic losses. The firm's long-run marginal cost curve, which reflects the principle of diminishing marginal returns, is a key determinant of its long-run production and profitability decisions.
• Analyze how a profit-maximizing monopolist uses marginal cost to determine its optimal output and price.
  • Unlike a firm in perfect competition, a monopolist faces a downward-sloping demand curve and can influence the market price. To maximize profits, the monopolist will produce the quantity where its marginal revenue (the additional revenue from selling one more unit) is equal to its marginal cost. This is because the monopolist can increase its profits by producing up to the point where the additional revenue from the last unit sold is just equal to the additional cost of producing that unit. The monopolist will then charge the highest possible price that consumers are willing to pay for that profit-maximizing quantity, leading to a higher price and lower output compared to a perfectly competitive market.

Related terms

Total Cost:

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

Average Cost:

The total cost divided by the quantity of output produced, representing the cost per unit of production.

Diminishing Marginal Returns:

The phenomenon where additional units of a variable input (like labor) lead to smaller and smaller increases in output, causing marginal cost to rise.