A2 Micro: High and Low Marginal Cost Products

Marginal cost is the change in total cost from supplying an extra unit or supplying to an extra consumer. In some markets and industries there is a clear marginal cost to producing for the next user. In others, the marginal cost is negligible, bordering on zero. How might this impact on the nature of supply and pricing?

Relatively high marginal cost

Extracting and refining an extra barrel of oil (the MC will vary by country)
Manufacturing a niche or designer product - e.g. a new sports car
A fully serviced hotel apartment
Supplying an extra unit to a customer where there is a clear and lengthy cost in terms of labour i.e. bespoke furniture, made to measure suits
The marginal cost of laying on extra train carriages or another aircraft at peak times

In contrast ..... relatively low marginal cost

Digital downloads
Apps from online stores
Marginal cost of an extra user at an all-you-can-eat buffet
Low MC of an extra user logging onto a wireless network or engaging in a Google search
Marginal cost of an extra passenger using a timetabled system with plenty of spare capacity

The marginal cost of supplying an extra unit of output is linked with the marginal productivity of labour. The law of diminishing returns implies that marginal cost will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases.

The marginal cost of oil

The marginal cost of oil is the expense of extracting an extra barrel of crude oil from below the ground. It is a widely held belief among economists who specialize in commodity prices that the long-run market price of something is determined fundamentally by the marginal cost of production. The resources that can be tapped at lowest cost are often done so first, and then as it becomes progressively harder to unearth such resources the market price must rise to provide an economic incentive to do so.

One problem is that, because oil is a non-renewable resource lying in geological structures that vary enormously in location, weather, depth and many other variables, the cost of extracting new supplies is hard to determine. Many OPEC countries – especially Saudi Arabia – have access to relatively cheap and elastic supplies of oil. But the same cannot be said of crude oil producers in Canada’s tar sands and oil companies who have sunk huge amounts of money into exploiting the oil available in deep-water facilities off the west coast of Africa or in Brazil.

When the market value is much higher than marginal cost, oil producers extract a high level of producer surplus for each barrel that makes it to the oil refineries.

The fact is that for many oil-exporting countries, the price for each barrel of crude oil extracted needs to be higher than the marginal cost of production for national governments to generate sufficient income to pay for ambitious public spending projects.

Oil companies need to know that the price they can command in the market will be persistently above the marginal extraction cost in order to cover the fixed costs of production and the expected rate of profit demanded by shareholders.