What is the Importance of Marginal Cost?

Marginal cost (MC) is the cost of the last unit produced in a manufacturing process, the last service performed, or the last unit consumed. It is an economic term that takes into account decreasing or increasing costs of producing or consuming extra goods and services. Marginal cost is often related to marginal revenue, marginal benefit, and average and total cost.

The concept of marginal cost is important for individuals producing or consuming multiple units. Economies of scale generally favor decreased marginal and average costs for additional inputs, although MC can increase once maximum production capacity is reached. Marginal cost often follows a curved line on a graph, first decreasing as the process becomes more efficient, and later increasing as additional production requirements make the process less efficient.

For example, a factory that is built to produce a product will require a large amount of upfront cost. Once built, however, the cost of producing each product will decrease because it will take very little energy to use the existing machinery to increase production. The factory will eventually reach its maximum capacity, however, and if additional products are desired a new factory will have to be built, the old one will have to compensate workers for overtime work, or a variety of other expenditures will be necessary to keep production going. In this case, the marginal cost will increase because the company will need to expend more energy, time, and money in order to continue producing additional goods.

Division of labor and specialization can also lower the cost of production for additional units. Many companies take advantage of the benefits of specialization in lowering their production or service costs. Enabling workers to specialize in certain tasks can streamline manufacturing processes. The assembly line is a popular example of this concept because it allows workers or machinery to perfect and optimize smaller responsibilities.

Marginal cost is also important for consumers looking to purchase additional units of a good or service. Stores will often take advantage of this in offering deals and sales, such as buy one, get one half priced or buy one, get one free (BOGO). Not only does this encourage shoppers to purchase multiple units, but it likely generates income for the company as well. Consumers are much more likely to buy a second item at half-price because the marginal cost is half of the original cost. In the case of BOGO deals that offer a free item, the MC is effectively zero.