Economic Concepts II

Understanding Marginal Cost

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It has been said "economists think every cost is fixed..." which is in fact correct in many cases.  As an economist, I am a firm believer that unless a business is willing to cut an item, that cost is fixed.  You would not believe the verbal brawling I have been through arguing that point.

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Are you cutting the front-desk staff?  No?  Then that is a fixed cost.  I don't give a damn what the textbooks tell us.

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Understanding fixed-costs can help us better understand our marginal cost.  The cost of producing and selling one more item.  Think another filing into a tooth for a dentist or another foot of driveway for a mason.

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Look at the graphics on the right.  You see selling price, labor cost, material cost, variable cost, and the company's fixed cost.  To understand the marginal cost, look at the cost for one unit vs. two.  Every line item changes but fixed cost.  So the first unit has all costs included.   A cost of $107,500/unit.  The second unit has additional line by line costs.  All costs double except the fixed cost portion.  The total cost increases to $115,000 but the average cost falls to $57,500.  More importantly the marginal cost, the cost to produce one additional unit falls to $7,500.  As more units are produced, the marginal cost continues to fall until the company reaches full capacity and needs to expand (new higher fixed-cost base).  See break-point analysis in Theory in Practice.

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What does this mean for profits?  As the company produces each extra unit, the cost of that next unit declines.  As you can see, at 50 units the average cost per unit is $9,500 and the company makes $500 per unit.  At 60 units the average cost per unit is $9166.67 and the company makes $833.33 per unit.  

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Most importantly, the company makes as much money on the last 10 units as it did on the first 50.

 

Where is your company in this set of equations?

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