Marginal Cost

Marginal means additional. Seth Godin in his recent blog post defines marginal cost as

The cost of the next item produced is called ‘marginal cost‘. It doesn’t include set-up fees, rent, years of training, insurance or all the other huge costs an organization might pay. It’s merely the cost of one more unit.

Here is an example to make this concept easier to understand. Average cost of flying a passenger may be $200. But the marginal cost is just an extra bag of peanuts and a can of coke. As long as the passenger pays more than the marginal cost, selling him a ticket is profitable.

We often think that marginal cost is same as average cost. But they are not. In the book The Economic Way of Thinking – Paul Heyne writes

It is important to distinguish between average and marginal. A manufacturer’s average cost of producing automobiles (which would be the total cost of production divided by the total number of cars the manufacturer produces) may be $25,000, but the marginal cost of producing an additional automobile (or an additional 1,000 automobiles) might be much lower, say, $10,000 per car. Costs associated with research, testing, design, molds, heavy equipment, and similar factors of production must be incurred whether the manufacturer is going to produce 1,000 units, 10,000 units, or 100,000 units. Such costs will clearly contribute to the average cost of an automobile, but they will change very little as additional units are produced. Thus, the marginal cost of additional units may be substantially less than the average cost. Should production be expanded or reduced? That choice should be based on marginal costs, which indicate the change in total cost due to the decision.

Business that sells undifferentiated (commodity) products in a highly competitive environment does not get benefited from marginal cost. Every player will try to price the product slightly above the marginal cost and there by eroding the profit potential for all the players. Why would they do that? It is better to sell the product at or above the marginal cost than not selling it at all. Airline industry is the best example for this. Munger once described airlines industry as “marginal cost with wings“. Excerpt from Elementary Worldly Wisdom

Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets, there’s destructive competition that destroys shareholder wealth. If it’s a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that’s been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

On the other hand consider consider social networks like Facebook and Linkedin. The marginal cost of signing up one additional member is almost zero. But each additional member add tremendous value to the entire network. In general marginal cost favors businesses that have differentiated products with brand names.

Next time when you eat in a buffet do not wonder how does the restaurant manage to serve unlimited food options at a cheap price. The restaurant owner knows what the marginal cost is and he prices the food at a price above the marginal cost.

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