How Marginal Costs Differ from Average & Total Costs

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  • 0:01 What Is a Marginal Cost?
  • 1:44 Different Costs
  • 2:51 Using All Three
  • 4:00 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

A major concern for producers is trying to figure out how much something costs to make. Through using marginal costs, total costs, and average costs, producers get a much better idea of the prices they should charge.

What Is a Marginal Cost?

Let's say you owned a toy company that had already paid off all of its fixed costs for labor and location. Remember that these costs are fixed because they don't change, no matter how many toys you make. You're running at full efficiency, and you get an order in from your biggest customer requesting that you ship 1,000 toys within the week. They are offering to pay 50% more because of the rush order.

Should you do it? Of course, the person with an economics background would say 'absolutely.' However, is that really the best course of action? To answer that question, we must look at the marginal cost involved. The marginal cost of a good is the cost to produce one more, and we have to look at the marginal cost of each toy from 1 to 1,000. Luckily for us, it's relatively simple to do.

If your toy factory is running at slightly under full efficiency, that means that it could absorb the extra 1,000 units with relative ease. Sure, you'll have to pay the variable costs that come with manufacturing each toy, from raw materials to incidental overtime for the employees involved. In this case, it makes perfect sense for you to take the order. But what if the machines your firm uses to make toys are already at full capacity? What if producing toys 587 and 588 would be fine, but producing toy 589 and beyond would require a whole new machine, or even a whole new factory? Is it still a wise decision? In this case, assuming it was a one-time order increase, probably not, since the cost of manufacturing the additional units would exceed any fair price you could charge.

Different Costs

Of course, while the marginal price of a good is useful, it doesn't really give us a complete picture of everything we need to know in order to make good business decisions. As a result, it probably doesn't surprise you to hear that there are two other types of costs that economists use when talking about businesses: average cost and total cost. Total cost is pretty straightforward; it's just calculated by totaling up the cost of everything that went into producing the goods in question. Notice that this includes both fixed costs and variable costs. Average cost is the average cost per unit manufactured, calculated by taking the total cost of manufacturing everything and dividing it by the total number of units manufactured.

Here's an example. Let's return to your children's toy company. In a given period of time, you made 2 million toys and paid $20 million in total costs to manufacture those toys. Your total cost during that period was $20 million, where the average cost of each toy was only $10.

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