Marginal costs and Marginal revenue

The marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of a product that will maximize profits.

A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point at which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.

Production costs include every expense associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.

Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries and wages, building rental payments or utility costs. Variable costs, meanwhile, are those directly related to, and that vary with, production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production.

Marginal Cost

In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it refers to the rate of change of total cost as output is increased by an infinitesimal amount.

To optimize marginal cost and revenue, it’s essential to understand a few standard production terms. Every business that generates production costs can divide them into two key categories:

• Fixed costs: These are essential expenses that stay relatively flat over time, even if your company increases production. For example, expenses related to equipment and facilities are considered fixed costs.
• Variable costs: These expenses are less consistent from day to day or month to month. Instead, they can rise or fall significantly depending on production levels. For example, raw materials and labour force are considered variable costs.

Short run marginal cost

Short run marginal cost is the change in total cost when an additional output is produced in the short run and some costs are fixed. In the on the right side of the page, the short-run marginal cost forms a U-shape, with quantity on the x-axis and cost per unit on the y-axis.

On the short run, the firm has some costs that are fixed independently of the quantity of output (e.g. buildings, machinery). Other costs such as labour and materials vary with output, and thus show up in marginal cost. The marginal cost may first decline, as in the diagram, if the additional cost per unit is high if the firm operates at too low a level of output, or it may start flat or rise immediately. At some point, the marginal cost rises as increases in the variable inputs such as labor put increasing pressure on the fixed assets such as the size of the building. In the long run, the firm would increase its fixed assets to correspond to the desired output; the short run is defined as the period in which those assets cannot be changed.

Long run marginal cost

The long run is defined as the length of time in which no input is fixed. Everything, including building size and machinery, can be chosen optimally for the quantity of output that is desired. As a result, even if short-run marginal cost rises because of capacity constraints, long-run marginal cost can be constant. Or, there may increasing or decreasing returns to scale if technological or management productivity changes with the quantity. Or, there may be both, as in the diagram at the right, in which the marginal cost first falls (increasing returns to scale) and then rises (decreasing returns to scale).

Marginal Revenue

Essentially the opposite of marginal cost, marginal revenue refers to the extra revenue your business can generate by selling one additional unit. This number is different depending on the market circumstances:

Perfectly competitive market: In this type of idealistic market, marginal revenue tends to remain constant because the market controls the sale price and your business has the power to sell as many units as possible. As a marginal cost and marginal revenue graph would show, the output is proportional to the revenue. Because costs decrease as you increase production, your company’s total profit grows.

Imperfectly competitive market: In this more realistic situation, marginal revenue tends to fluctuate when supply and demand affect the market. In this type of monopoly market, your business can’t continue to make and sell more products at the same sale price. Instead, you have to lower the sale price. Eventually, marginal costs may exceed marginal revenue, which negates any profit. You can use the perfect market as a standard to compare to your real-world market in order to measure its efficiency and effectiveness.

Marginal revenue = Change in total revenue / Change in quantity

Marginal Revenue vs. Marginal Cost

When you adjust for marginal revenue, the cost may also change, which can affect your optimal production levels. To compare marginal cost vs. marginal revenue, it’s helpful to understand how these two numbers behave in relation to one another:

• If marginal revenue is higher than marginal cost, your company should raise production levels to improve efficiency and generate more profit overall.
• If marginal cost and marginal revenue are equal, your business has reached its optimal production level. At this level, efficiency has reached its peak, and you’ve maximized profits.
• If marginal cost is higher than marginal revenue, your business should lower production levels to reduce profit loss.