In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.
A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information asymmetries, the presence of negative or positive externalities, transaction costs, price discrimination and others.
Since (by definition) fixed costs do not vary with production quantity, it drops out of the equation when it is differentiated. The important conclusion is that marginal cost is not related to fixed costs. This can be compared with average total cost or ATC, which is the total cost divided by the number of units produced and does include fixed costs.
For discrete calculation without calculus, marginal cost equals the change in total (or variable) cost that comes with each additional unit produced. For instance, suppose the total cost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. The marginal cost of producing the second shoe is $40 - $30 = $10.
A long-run cost function describes the cost of production as a function of output assuming that all inputs are obtained at current prices, that current technology is employed, and everything is being built new from scratch. In view of the durability of many capital items this textbook concept is less useful than one which allows for some scrapping of existing capital items or the acquisition of new capital items to be used with the existing stock of capital items acquired in the past. Long-run marginal cost then means the additional cost or the cost saving per unit of additional or reduced production, including the expenditure on additional capital goods or any saving from disposing of existing capital goods. Note that marginal cost upwards and marginal cost downwards may differ, in contrast with marginal cost according to the less useful textbook concept.
Economies of scale are said to exist when marginal cost according to the textbook concept falls as a function of output and is less than the average cost per unit. This means that the average cost of production from a larger new built-from-scratch installation falls below that from a smaller new built-from-scratch installation. Under the more useful concept, with an existing capital stock, it is necessary to distinguish those costs which vary with output from accounting costs which will also include the interest and depreciation on that existing capital stock, which may be of a different type from what can currently be acquired in past years at past prices. The concept of economies of scale then does not apply.
Much of the time, private and social costs do not diverge from one another, but at times social costs may be either greater or less than private costs. When marginal social costs of production are greater than that of the private cost function, we see the occurrence of a negative externality of production. Productive processes that result in pollution are a textbook example of production that creates negative externalities.
Such externalities are a result of firms externalising their costs onto a third party in order to reduce their own total cost. As a result of externalising such costs we see that members of society will be negatively affected by such behaviour of the firm. In this case, we see that an increased cost of production on society creates a social cost curve that depicts a greater cost than the private cost curve.
In an equilibrium state we see that markets creating negative externalities of production will overproduce that good. As a result, the socially optimal production level would be lower than that observed.
When marginal social costs of production are less than that of the private cost function, we see the occurrence of a positive externality of production. Production of public goods are a textbook example of production that create positive externalities. An example of such a public good, which creates a divergence in social and private costs, includes the production of education. It is often seen that education is a positive for any whole society, as well as a positive for those directly involved in the market.
Examining the relevant diagram we see that such production creates a social cost curve that is less than that of the private curve. In an equilibrium state we see that markets creating positive externalities of production will under produce that good. As a result, the socially optimal production level would be greater than that observed.
Of great importance in the theory of marginal cost is the distinction between the marginal private and social costs. The marginal private cost shows the cost associated to the firm in question. It is the marginal private cost that is used by business decision makers in their profit maximization goals, and by individuals in their purchasing and consumption choices. Marginal social cost is similar to private cost in that it includes the cost functions of private enterprise but also that of society as a whole, including parties that have no direct association with the private costs of production. It incorporates all negative and positive externalities, of both production and consumption.
Hence, when deciding whether or how much to buy, buyers take account of the cost to society of their actions if private and social marginal cost coincide. The equality of price with social marginal cost, by aligning the interest of the buyer with the interest of the community as a whole is a necessary condition for economically efficient resource allocation.