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Marginal cost and total cost are related in terms of the cost of production for manufacturing companies or service providers. Fixed costs and marginal variation in cost are both considered when determining the total cost, so total costs encompass marginal costs. The average total cost will generally decrease to a minimum before increasing, forming a U-shape. Marginal cost and total cost will often intersect on a graph, although marginal cost curves can take on different shapes, depending on the process.
When determining marginal cost and total cost, companies must first calculate upfront fees and fixed costs. These costs cannot be varied, and are necessary for the process to occur. Examples of these would include rent, manufacturing equipment, a minimum number of employees, or other costs that will not change with the output production. The costs will ultimately be high when compared to the marginal cost of production, but they will factor into the average total cost per unit along with marginal cost.
An example of marginal cost and total cost is in the drug development industry. Fixed cost and upfront costs are incredibly high, and they include everything from hiring research specialists to conducting experiments to purchasing manufacturing equipment to make the medications. Additional fixed costs, which contribute to the total costs, would include clinical trials, marketing campaigns, and costs involved in regulation and certification. These are often necessary for the industry to generate an income stream and do not vary based on how many units of a drug are produced.
Marginal cost will likely be low for producing extra units of the drug. Once the research has been conducted, the drug has been developed, and the manufacturing equipment and factories have been created, it will not cost much at all to produce one pill. In this way, a company is able to produce large quantities of medications without drastically increasing costs. Companies take advantage of low marginal costs to recoup their high fixed costs through drug sales.
The drug development industry is an example of an industry that produces products with low marginal cost but high average total cost. Since the cost of research and development, as well as the cost of machinery, must be factored in when determining total cost, the average cost of each pill will be quite high. Low marginal costs can offset some of these high fixed costs, enabling companies to justify a higher total cost.