Marginal cost is the cost of producing one extra unit of product. It does not contain any fixed cost like monthly rents, machine cost or any other costs that does not vary with the no of units of products being produced. Total cost of production of a unit of product consists of marginal cost as well as costs that are fixed. Fixed cost/unit of product is taken into account while calculating total cost of production of a unit of product.
To produce a good companies incur broadly 2 types of cost.
a. Fixed cost- Fixed cost associated with the production regardless of the quantity being produced
b. Variable cost- Cost of material and extra labour/energy used for production; proportional to the quantity of goods produced
If the companies current production cost is taken care of by the current revenue, the cost of producing one extra unit (marginal unit) will comprise of just variable cost. So if a company is selling that product at a price above the marginal cost (here variable cost) but below its total cost, company is still able to make profit, since it’s selling it above marginal cost.
Suppose a company is printing books.
Fixed cost includes- Machine cost- 1000000 that can produce 100000 books, Monthly rent for production facility- 20000 with 10000 books being produced each month(20000*10=200000 for 100000)
Unit fixed cost- machine cost- 10/ book, rent- 2/book
Variable cost – Page and ink cost- 200pages/book @ 50 paise= 100 rupees, Electricity and labour= 10/book
So, total variable cost= 100 +10=110/book; total fixed cost= 12/book(if the fixed cost is divided among the no of books produced)
Total cost of production= 122/book; marginal cost= 110/book
If company is selling books at 130; profit above marginal cost=20; (1000000+200000)/20= 60000; so producing just 60000 will take care of all the fixed cost invested in the production facility.
Company need to sell 100000 units to recover total cost
Note- fixed cost has been incurred before production and is fixed no matter how many books are being produced; it is divided among no of books produced to calculate the spread of that fixed cost on each book
So, if the company after selling 60000 books starts selling just above marginal cost that is, let’s say 115 but below total cost- it is not accruing any loss although getting less profit.
In this way company is able to reduce the price without accruing any loss.
Since the company is able to reduce the price it sets a pressure in the book industry for all producers to reduce the price and customer starts expecting low cost on book as a whole. This is one of the disadvantages of selling by marginal pricing.