Marginal Cost Theory

Marginal Cost Definition

The increase in costs that occurs when producing an additional unit of output

Why is marginal cost theory important?

Used to determine at what point in organization can achieve economics of scale. A company want to achieve the highest profit possible, but if the price is too high noone will buy the item

Long-run marginal cost

addition to total cost resulting from producing one additional unit of output when all the factors of production are variable the minimum increase in total cost associated with an increase of one unit of output when all inputs are variable

Sunk costs

costs that have already been incurred and cannot be recovered For example: Power stations, plants, birdges etc are expensive to build. When they are built they cannot be used for other things and the invetment has been made. Such facilities are said to have sunk costs.

Merit order

A way of ranking available sources of electrical generation Works so that the plants with lowest marginal costs are the first ones to be brought online to meet demand, and the plants with highest marginal costs are the last to be brought online.

Fixed costs

Costs that do not depend on demand

short marginal cost

the cost of producing a small amount of additional units of a good or service

External costs Examples of positive & negative external costs

when prices do not include all the costs, they have external costs Positive: People get jobs and have money to buy things Negative: Costs for pollution which are paid by a third party in the form of health problems.

Marginal cost should be used for products that meet these prerequisites:

- Large systems where the "building" cost is very high - Systems owned by society - If we want to achieve optimal conditions on the market - If we want the market to decide what to do

Marginal cost for power supply depends on following parameters

- The demand itself - Composition of merit order - Operating costs

Zero or negative marginal cost

Ex: During summer deman for heat from district heating is low. But it is not possible to store garbage so we must burn it even if it is not necessary. The marginal cost is then very low or egative and the use of district heat should be priced accordingly. The only way for negative marginal cost is for a decrease in total cost, which just does not happen in a real world filled with scarcity, limited resources, unlimited wants and needs, and opportunity cost.

Why is it difficult to calculate marginal cost for district heating?

Too many alternatives/option for energy - Too many plants - A plant can manufacture two commodities - A plant can perform two services (waste destruction & CHP production)