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Marginal cost is the additional cost of producing one more unit of a product. In a competitive market, marginal cost and supply are the same, but in a less competitive market, they differ. As production increases, marginal cost initially declines, but eventually rises due to the law of diminishing returns. In a perfectly competitive market, firms set production rates where price equals marginal cost to maximize profits. In a non-competitive market, the company determines production rates based on demand rather than marginal cost.
In economics, marginal cost is the additional cost associated with producing one additional unit of a product. Companies rely on this information to help them make decisions related to pricing and production targets. In a purely competitive market, marginal cost and supply will always be the same. Graphically, both can be illustrated by the same upward-sloping cost curve, and they will overlap each other at every price point. However, in a market that is less than perfectly competitive, the relationship between marginal cost and supply changes and the two values are no longer equal.
As price levels increase, the amount of goods and services that firms produce will also increase. For example, a company that makes cars will sell a certain number of units at one price, but if the market price rises, the company will make more cars to maximize profit. The reverse is also true, resulting in decreased production as market prices fall.
This same type of relationship can also be seen when examining marginal cost, although for different reasons. The law of diminishing returns states that as firms increase the resources needed to increase production, marginal cost will decline, bottom out, and then begin to rise. To understand why, consider a car factory with 100 workers. Adding 25 more workers can help increase production and reduce the marginal cost of each new car. However, if the company were to add another 100 workers, these employees would begin to slow each other down or get in the way of each other, resulting in an increase in marginal cost.
From this example, it can be seen that as the offer increases, the price will automatically increase as well. In a perfectly competitive market, firms will set production rates at the exact point where price equals marginal cost. By doing so, they are able to maximize profits and efficiency. Since the price is constantly fluctuating due to natural market forces, production rates or supply will also continually change. This relationship between marginal cost and supply holds at each price point, and continues to hold as the price fluctuates.
In a market that is not perfectly competitive, this relationship between marginal cost and supply no longer holds. For example, a company that has a monopoly on the market does not have to respond to price changes because it can set prices for a product. In this type of market, the company determines production rates based on demand rather than marginal cost.
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