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What is 'Marginal Cost Of Production'

The marginal cost of production is the change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale.

BREAKING DOWN 'Marginal Cost Of Production'

The marginal cost of production calculation is most often used among manufacturers as a means of isolating an optimum production level. Manufacturers often examine the cost of adding one more unit to their production schedules. This is because at some point, the benefit of producing one additional unit and generating revenue from that item will bring the overall cost of producing the product line down. The key to optimizing manufacturing costs is to find that point or level as quickly as possible.

Marginal cost of production includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. 

Marginal cost is an important factor in economic theory because a company that is looking to maximize its profits will produce up to the point where marginal cost (MC) equals marginal revenue (MR).

How Marginal Cost of Production Works

Production costs consist of fixed costs and variable costs. Variable cost refers to the costs required for each unit of output. Fixed costs refer to overhead costs that are spread out across units of output.

For example, consider a hatmaker. Each hat produced requires seventy-five cents of plastic and fabric. Your hat factory incurs $100 dollars of fixed costs per month. If you make 50 hats per month, then each hat incurs $2 of fixed costs. In this simple example, the total cost per hat, including the plastic and fabric, would be $2.75 ($2.75 = $0.75 + ($100/50)).

But if you cranked up production volume and produced 100 hats per month, then each hat would incur $1 dollar of fixed costs, because fixed costs are spread out across units of output. The total cost per hat would then drop to $1.75 ($1.75 = $0.75 + ($100/100)). In this situation, increasing production volume causes marginal costs to go down.

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