Economics
4 Types of Market Competitions You Should Know
Learn about the market structure and the four types of market competitions. Read about their characteristics and go over an example for each.
Mendy Wolff
Subject Matter Expert
Outlier Articles Home
Economics
Marginal Benefit vs Marginal Cost
07.14.2022 • 9 min read
Mendy Wolff
Subject Matter Expert
This article looks at marginal benefit vs marginal cost and the formula to calculate them. Read also about the different components, examples, and faqs.
In This Article
If you were a company and there was a way to maximize profits, would you want to know it? Marginal benefit and marginal cost are essential to know in the business world. We'll thoroughly go over both with examples.
Marginal Benefit and Marginal Cost
The marginal benefit and marginal cost are measurements of the cost or value of adding a unit of goods. The marginal benefit arises from the buyer's point of view, as it measures the cost a consumer is willing to pay for one more unit of goods. Marginal cost stems from the seller's point of view, as it calculates the added cost for the seller in producing one more unit of goods.
Marginal benefit and marginal cost are both essential for business managers in calculating the optimal amount of production.
For a business to maximize profits, it calculates its marginal benefit and its marginal cost. If they can produce one more unit of a good and sell it at a higher price than its marginal cost, it can increase profits by increasing its output. However, suppose the additional units produced will not sell at a higher price than the marginal cost of production. In that case, it should not increase its output. Each additional good produced will cost the business more than it can earn from selling each additional unit.
The relationship between marginal cost and marginal benefit is pretty dynamic. This is because the marginal cost for each unit can vary depending on the economies of scale. For example, as a company scales production, the cost of producing each additional unit decreases. And on the consumer side, the marginal benefit changes with each additional unit consumed; the outcome is that with each unit bought, the less money the consumer is willing to pay for the next unit. So companies have to constantly figure out the "max amount" of money a consumer is willing to pay for the added unit.
Market equilibrium happens when marginal cost equals marginal benefit. This simply means that sellers produce the exact amount of goods buyers want, and no benefit is wasted. When the market is not at equilibrium, there is an inefficiency occurring. The number of units produced should increase or decrease.
What Is Marginal Cost?
Marginal cost is the additional cost a producer or any business incurs by adding one more unit of production or sales. For example, suppose a company manufactures wireless headphones and increases its production output from 10,000 headphones a week to 12,000 a week. The additional cost of producing the added 2,000 headphones will be the marginal cost.
The marginal cost is a crucial component in finding a company’s profit maximization. It helps managers find the optimal amount of production for the business to become most profitable.
Marginal Cost Formula
Marginal cost is the change in total cost divided by the change in the number of units produced.
How To Calculate Marginal Cost
Let's use an example to see how we calculate the marginal cost:
Let us assume HeadPhone Inc. is a manufacturer of wireless headphones. It currently manufactures 10,000 headphones for a total cost of $10,000 every month. Suppose HeadPhone's business managers calculate that producing 12,000 headphones would cost $11,000.
The change in total cost ($11,000 - $10,000) divided by the change in units manufactured (12,000 units – 10,000 units) yields the marginal cost of the additional 2000 headphones.
The marginal cost is the incremental expense the business takes on to produce the extra 2000 units of headphones, which is $2,000.
5 Cost Components
When we calculate the marginal cost, we do not include fixed costs. We do when the new level of output is so significant that it will change the company's fixed costs.
Below is a list of different components included in the marginal cost. As you will notice, they are all variable costs—costs that can change relative to the amount of production.
1. Unit Costs
This is the added individual cost for each additional unit manufactured. Using our example of headphones, the cost of materials like plastic or wires will change to produce more headphones.
2. Batch Costs
This refers to the cost of each additional batch in production. For example, suppose a headphone molding machine costs a certain amount every time they use it. In that case, the company might want to optimize how many headphones they can produce within each batch. That way they don't have to run extra batches to produce more headphones.
3. Product Costs
This typically refers to the cost of designing a product or the cost of marketing and promoting the product.
4. Customer Costs
This includes customer service or relations costs. For example, a company will have to expand its customer services representatives if they decide to increase production.
5. Organization Costs
This accounts for general business costs associated with operations. For example, if a company expands its production, it might have other general costs that will go up, like insurance or salaries, etc.
Let’s calculate HeadPhone’s marginal cost of producing more headphones. Combine the change in all the operational (variable) costs and divide it by the change in the number of units they make. If their marginal cost is less than their marginal benefit, they should expand production.
What Is Marginal Benefit in Economics?
Marginal benefit is a term used for both consumers and producers when calculating an additional unit of production or consumption. The word "marginal" is the way economists add “one more” unit of goods or services to a basket of the same goods.
Consumers’ Marginal Benefit
The marginal benefit for consumers calculates the additional utility gained from adding “one more” unit of additional consumption to the same basket of goods. For example, when someone adds a second slice of pizza to their lunch order, the utility—i.e., the satisfaction—they gain from that second slice of pizza is the marginal benefit.
The marginal benefit decreases with each added unit of goods. This is because of the law of diminishing marginal utility. This means that the benefit received from each extra unit decreases with each additional unit. Think about it. How many slices of pizza will it take for you to have no additional benefit from adding “one more” slice to your lunch order? Or if you own three pairs of sneakers, the satisfaction gained from buying an additional pair is less than the satisfaction you got from buying the second pair.
Producers’ Marginal Benefit
The marginal benefit for producers calculates the additional revenue made from each additional unit produced and sold. This is why economists often refer to producers' marginal benefit as marginal revenue. For example, let's assume someone owned a Doughnut factory where they could produce and sell 5,000 doughnuts a day. One morning, they decide they want to produce and sell more than 5,000 doughnuts; the added revenue they would make from producing and selling more doughnuts will be their marginal benefit—marginal revenue.
Here’s a deeper explanation of marginal revenue and marginal cost:
To calculate whether expanding production—like making more doughnuts—will be profitable, we need to know the marginal cost for each additional unit produced.
Marginal Benefit Formula
To calculate the marginal benefit, we divide the change in total benefit received by the change in the number of units consumed.
To better understand how we calculate consumers' marginal benefit, let’s elaborate on our pizza example.
First, it's important to realize that when calculating the utility of any consumption, we use dollar values. This is because every time someone buys something, they are calculating their opportunity cost. That is they are trying to get the most utility with the least amount of money.
This explains why in microeconomics, we refer to the marginal benefit as the "maximum amount" of money a consumer is willing to pay for something. Since the value of consumption for each additional unit declines, the "max price" the buyer is willing to spend will depend on whether it is the first unit they are buying or the second or third, etc.
Let's assume the dollar value of the utility from eating two slices of pizza is $6, and the total utility received from eating three slices of pizza is $8. To find the marginal benefit, we divide the change in utility ($8 - $6) by the change of units consumed (2 slices – 1 slice). We get the marginal benefit of the third slice as $2.
3 Different Marginal Benefits and What They Mean
As we now know, the marginal benefit calculates the effect of each additional unit consumed. This leads us to the three different outcomes that can happen when a consumer adds a unit of goods or services to their purchase:
1. Positive Marginal Benefit
A positive marginal benefit when consuming more units of a good or service leads to added satisfaction or happiness. For example, a second slice would bring additional satisfaction to someone who likes eating pizza for lunch. This makes the marginal benefit from the added slice positive.
2. Negative Marginal Benefit
A negative marginal benefit occurs when consuming too much of a particular good has a negative outcome. For example, the sixth slice of pizza will cause the person to get sick. So the marginal benefit from adding the 6th slice of pizza is negative.
3. Zero Marginal Benefit
Zero marginal benefit occurs when the consumer is indifferent to adding another unit. There is no additional satisfaction from an extra unit, but there is also no adverse outcome. For example, let’s consider an already full-on-pizza individual. If they order a third slice of pizza and can't take the pizza to-go but would not get sick from eating an additional slice, then the marginal benefit is zero.
Maximizing Marginal Benefits
Marginal benefit is always the highest during the consumption of the first unit bought and decreases with each additional unit. The decline in marginal benefit is simply a function of the diminishing rate of satisfaction associated with the consumption of each additional unit. Again, that is why the marginal benefit is thought of as the "max amount" a consumer is willing to pay. Since the satisfaction decreases with each additional unit, the amount one is willing to spend on it also decreases.
Buy One, Get One Half-Off
Understanding the consumers' marginal benefit explains the often used "buy one, get one half-off" store promotion. The consumer is not willing to pay as much money for the second pack of cookies as the first pack of cookies because of the diminishing utility. So if the store wants to sell more cookies to that customer, they will have to decrease the price for the second unit, since the customer’s marginal benefit decreases.
Marginal Cost and Marginal Benefit FAQs
Should the Marginal Cost Be More Than Your Marginal Benefit?
No. If the marginal per unit cost is greater than the marginal benefit received, the company will lose money.
The general rule is:
Marginal Revenue < Marginal Cost = Decrease Production
Marginal Revenue > Marginal Cost = Increase Production
Marginal Revenue = Marginal Cost = Profit Maximized
How Do I Calculate the Marginal Cost?
Marginal cost is the change in total cost divided by the change in the number of units produced.
How Do I Calculate the Marginal Benefit?
Marginal benefit is the change in utility received by the change in the number of units consumed.
Explore Outlier's Award-Winning For-Credit Courses
Outlier (from the co-founder of MasterClass) has brought together some of the world's best instructors, game designers, and filmmakers to create the future of online college.
Check out these related courses:
Related Articles
Economics
Economic Efficiency: A Complete Guide
Learn what economic efficiency is, its relationship with demand and supply, and efficiency and equilibrium in competitive markets.
Mendy Wolff
Subject Matter Expert
Economics
What Is the Free Rider Problem? [With 5 Solutions]
Learn what the free rider problem is, its relationship with public goods, and read an example using a prisoner’s dilemma game plus five solutions.
Sarah Thomas
Subject Matter Expert