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Understanding Marginal Costs

A Hopefully Not Too Economic Explanation Of This Critical Economic Concept

The concept of marginal costs is one that you learn early on in Economics 101. As everything else in economics, it feels pretty abstract and random when you first hear about it. But it’s actually an incredibly important business and investing concept. In this post (and probably several future ones), I hope to shed some light on why it’s critical for investors to analyze and understand both a company’s and its industry’s marginal cost structure before they decide whether or not to invest.

Definition

The technical definition is the incremental cost (in other words the change in total cost) of producing one more unit. A few key things to note about marginal cost:

• It consists mainly of variable costs. For example, if Intel produces one more chip, Intel’s marginal cost is the change in the total cost of labor, raw materials, and electricity caused by increasing production level by that chip.
• Fixed costs are not included (since we are dealing with the short-run). So in our Intel example, the upfront cost of building the fab is not included in the marginal cost of a chip. The reason for this is that fixed costs are constants and the marginal cost is basically a…