Marginal cost is defined as the cost added by producing one more unit of a good or service. It is sometimes also referred to as the cost of the last unit. The concept of marginal cost is an essential part of economic theory because it is the counterpart to marginal revenue and one of the foundations of profit maximization. Thus, if you are attending any economics classes, you’ll most likely have to calculate marginal cost at some point. Luckily, this is not rocket science. We can calculate marginal cost by following three simple steps: (1) calculate the change in costs, (2) calculate the change in quantity, and (3) divide change in cost by change in quantity. We will look at each of these steps in more detail in the video below.
1) Calculate Change in Cost
First, we have to compute the change in total cost. In most cases, costs increase or decrease according to the level of output. A higher output usually results in higher costs while a lower output results in lower costs. The reason for this is the presence of variable costs. Variable costs are directly related to the production volume and therefore increase or decrease accordingly. In addition to that, step costs (or step fixed costs) can also push costs, if specific levels of output are reached. Now, calculating the change in cost is simple. All we have to do is take the total cost before the change in output (i.e., old cost) and subtract it from the total cost after the change (i.e., new cost). This results in the following change in cost formula:
Change in cost = new cost – old cost
To give an example, let’s assume you own a burger restaurant: Deli Burger. Yesterday you sold 100 burgers, which resulted in total costs of USD 300 (i.e., this includes all fixed costs + total variable cost). Today you sell 102 burgers. Therefore you need two additional patties, more buns, more lettuce, etc. As a result, your total cost increases to USD 304. Hence the change in cost is USD 4.00 (304 – 300).
2) Calculate Change in Quantity
Next, we have to compute the change in quantity. A change in the level of output is synonymous with a change in quantity. That is, when the production level increases, the quantity supplied of a good or service increases and vice versa. Computing a change in quantity works just like computing a change in cost. All we need to do is take the quantity before the change in output (i.e., old quantity) and deduct that from the quantity after the change (i.e., new quantity). This gives us the following formula:
Change in quantity = new quantity – old quantity
In the case of Deli Burger, the change in quantity is 2 additional units, i.e., burgers (102 -100). Please note, even though the marginal cost is defined as the change in cost incurred by producing one more unit of a good or service, we can still calculate it for any given number of additional units.
3) Divide Change in Cost by Change in Quantity
Finally, we can compute the marginal cost by dividing the change in cost by the change in quantity. To understand why we do this, just take another look at the definition: marginal cost is the cost incurred by producing one additional unit of output. In other words, it is the per-unit increase in total cost. However, because it depends on the change in cost and the change in quantity, marginal cost can vary as the current level of output changes. That means the marginal cost of selling 11 instead of 10 units may be different from the marginal cost of selling 101 units instead of 100 (even though the change in quantity is the same). Hence, we can use the following marginal cost formula:
Marginal cost = change in cost / change in quantity
Going back to our Deli Burger example, let’s calculate the marginal cost for your 101st and 102nd burgers. If we plug the numbers from above into our formula, we get the following equation: USD 4.00 / 2 burgers = USD 2.00. Hence, the marginal cost of producing two additional burgers at this point is USD 2.00 per burger.
Summary
Marginal cost is defined as the cost incurred by producing one more unit of a product or service. This is an important concept in economic theory because it is the counterpart to marginal revenue and one of the foundations of profit maximization. We can calculate marginal cost by following three simple steps: (1) calculate the change in costs, (2) calculate the change in quantity, and (3) divide change in cost by change in quantity.