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 maximize its profit, and the relationship between marginal revenue and the marginal cost of production helps to find the point at which this occurs. The point at which marginal revenue equals marginal cost maximizes a company’s profit.
Calculating Marginal Cost of Production
Production costs include every expense associated with making a good or service. These costs are broken down into fixed costs and variable costs. Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. Fixed costs include general overhead expenses like salaries and wages, building rental payments or utility costs. Variable costs 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.
Total production costs include all the expenses of producing product at current levels: A company that makes 150 widgets has production costs for all 150 units it produces. The marginal cost of production is the cost of producing one additional unit. For example, say the total cost of producing 100 units of a good is $200. The total cost of producing 101 units is $204. The average cost of producing 100 units is $2, or $200 ÷ 100; however, the marginal cost for producing unit 101 is $4, or ($204 – $200) ÷ (101-100).
At some point, the company reaches its optimum production level, the point at which producing any more units would increase the per-unit production cost. In other words, the additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level may involve paying prohibitively high amounts of overtime pay to workers, or the maintenance costs for machinery may significantly increase.
The marginal cost of production measures the change in total cost of a good that arises from producing one additional unit of that good. The marginal cost (MC) is calculated by dividing the change (Δ) in the total cost (TC) by the change in quantity (Q). Using calculus, the marginal cost is calculated by taking the first derivative of the total cost function with respect to the quantity: MC = ΔTC/ΔQ.
Marginal costs of production may change as production capacity changes. If, for example, increasing production from 200 to 201 units per day requires a small business to purchase additional business equipment, then the marginal cost of production may be very high. However, this expense may be significantly lower if the business is considering an increase from 150 to 151 units using existing equipment.
A lower marginal cost of production means that the business is operating with lower fixed costs at a particular production volume. If the marginal cost of production is high, then the cost of increasing production volume is also high and increasing production may not be in the business’s best interests.
Calculating Marginal Revenue
Marginal revenue measures the change in the revenue when one additional unit of a product is sold. Assume that a company sells widgets for unit sales of $10, sells an average of 10 widgets a month and earns $100 each month. Widgets become very popular, and the same company can now sell 11 widgets for $10 each for a monthly revenue of $110. Therefore, the marginal revenue for the 11th widget is $10.
The marginal revenue is calculated by divi…