A bakery already pays rent, insurance, and salaries. Those costs do not change whether it bakes one hundred loaves or one hundred and one. But the flour, yeast, and electricity for that extra loaf do cost something. That extra expense is the marginal cost, the additional cost of producing one more unit.

Marginal cost matters because it drives decisions. A firm will keep producing as long as the revenue from the next unit exceeds its marginal cost. If it costs five dollars to make one more widget and the widget sells for six, the firm makes money on that unit. If the widget sells for four, the firm loses money and should cut back. This logic, known as marginal analysis, is the foundation of modern microeconomics.

Marginal cost often falls at first, as fixed costs get spread over more units, then rises as capacity limits bite. A factory can hire more workers and boost output cheaply at first. Eventually, the floor gets crowded, overtime pay kicks in, and machines break down more often. The marginal cost curve turns upward. Where it crosses the marginal revenue curve is the profit-maximizing level of output.

Related cost concepts

• Fixed cost: does not vary with output
• Variable cost: rises with output
• Average cost: total cost divided by quantity
• Marginal cost: cost of one more unit