What is the Relationship Between Marginal Cost and Total Cost?
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.
@allenJo - Well, I worked in the telecommunications industry for ten years, where we weren’t “making” anything. We provided phone service, and we had massive upfront capital investment in order to provide that network.
For us calculating the total fixed cost involved the costs of buying and maintaining all that equipment. As an industry, however, making money should have been a slam dunk. Once your infrastructure is in place then all you do is sell service – and we had lots of capacity to accommodate that service.
We believed the line, “Build it and they will come.” However, we built it, and they never came, at least not in the quantities needed to justify all that infrastructure.
I envy you. I think software is the industry to be in.
@nony - That’s why manufacturing takes such a hit in the United States. It costs a lot of money to make stuff. There’s intensive capital investment in the plants, assembly lines and things like that.
Manufacturing is real goods. It’s not vaporware. Contrast that with the industry I’m in, software. We sell digital goods. There’s high personal capital – we need programmers to develop the products we sell. But the products themselves are distributed on CDs, which cost almost nothing.
Either way you have high costs somewhere but I think that in the short run average total cost is less in the software industry than it is in the manufacturing sector.
Now you know why drugs are cheaper in Canada, and why some Americans regularly get their medication north of our border.
The U.S. pharmaceutical industry has a high total fixed cost, including the fixed costs which include how much it costs to conduct research and development. We’re talking billions of dollars here.
Once the drug is produced however, each additional unit of the drug costs almost nothing to make as the article correctly points out. However, generic brands of the drug (which Canada has a lot of) can be sold in mass volume for pure profit to the distributors.
That’s because the distributors incur no research and development costs. Their only expense is the unit cost of the generic drug. So they sell it cheaper, and for high profit margins. People need to take these things into consideration when they complain that drugs in the U.S. are more expensive than those in Canada.
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