The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Marginal Cost and Supply

            As long as people will accept crap, it will be financially profitable to dispense it.
                                                             ...former TV talk show host Dick Cavett

            Economists often ask about the additional or marginal effects of an action.  For example, if producing one more item raises a firm’s total costs from $120 to $125, the marginal cost is $5.  Marginal cost (MC) is the change in total cost from producing one more unit.  Similarly, marginal benefit (MB) is the change in total benefit or value we get from consuming one more unit of an item.

            Remember that costs to an economist are opportunity costs -- the value of what we must sacrifice.  To illustrate the concept of marginal costs in more detail, assume that you have five possible activities, each of which will take exactly one hour, that have the following values:

            Activity              Value

                 A                    $1
                 B                    $3
                 C                    $5
                 D                    $7
                 E                     $9

                 Given these numbers, what is the cost of sleeping late?  Sleeping late will force you sacrifice additional activities.  For each additional hour of sleep you must sacrifice one additional activity.  You would sacrifice the least valuable activities first.  That is, if you were to sleep one additional hour you would choose to sacrifice activity A because A is less valuable than the others.  Since Activity A is worth $1, the MC of sleeping that first extra hour is $1 -- the value lost by sacrificing activity A for the sleep.

                 Do you see how to do this?  What is MC of sleeping a second extra hour?  To sleep a second hour you must sacrifice a second activity.  Which will you sacrifice next?  Activity B; it is the next least valuable activity.  The MC of the second extra hour of sleep is $3 -- the value lost by sacrificing activity B.  Similarly, the MC of sleeping a third extra hour is $5, a fourth extra hour is $7 and a fifth extra hour is $9.  The total cost of sleeping five extra hours is 1 + 3 + 5 + 7 + 9 = $25.

                 Note that MC is rising as the quantity of sleeping rises.  This is typical.  You must sacrifice increasingly more valuable options as the quantity of sleep rises.  The same concept holds for producing other types of products.  For example, some oil deposits are relatively inexpensive to tap.  The deposits are large, close to the surface, in easily accessible areas.  Other deposits are more expensive to tap.  They are smaller, require drilling deeper into the earth, and are located in less accessible areas.  If we want only a small quantity of oil we could tap the cheaper deposits first.  But to produce more oil, we must start tapping the more expensive sources.  The MC of oil will rise as output rises.  Got it?

                 Add another piece.  How many extra hours should you sleep?  Rational students will sleep only if the expected benefit is at least as great as the expected cost.  If the expected benefit of extra sleep is $0.50 per hour, will you sleep in?  Hopefully not.  The MC of sleeping the first extra hour in our example was $1; that’s more than the $0.50 benefit.  What should you do if the expected benefit of extra sleep is $7. A rational student would sleep an extra four hours. The $7 expected benefit per hour covers the MC of hours one through four.  However do not sleep the fifth extra hour.  The fifth extra hour involves a MC of $9, greater than the expected $7 benefit. 

                 Oil producers react the same way.  If the price of oil is $30 per barrel, they will want to keep producing as long as the $30 they get for each barrel covers the MC of the oil.  They will produce as long as the price or benefit they get from selling the oil covers the MC.

                  Look at this with the graph below:

            If firms can sell their goods at a price of P₀ they will find it profitable to keep producing as long as the price covers the MC.  Q₀ will be their most profitable output.   Or, if you can get a benefit of P₀ for each extra hour of sleep, Q₀ is the optimal number of extra hours you should sleep. Of course we could draw a similar graph for any price. If the price rises, so will the optimal quantity to be produced.  Can you draw an example?

            Wait.  Does this seem familiar?  We are taking a price and drawing a line over to the MC to see what will be produced.  That’s exactly what we did for supply curves.  In fact, MC determines how many units a firm will supply.  The MC curve is the supply curve!  All those supply curves we drew earlier were nothing more than MC curves in disguise. Wow.  You might want to take a few deep breaths to calm down before proceeding further.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Explain the concept of marginal cost.

2.         Explain why marginal costs tend to rise as output rises.

3.         Explain why marginal cost curves are supply curves.

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