Spring Break is right around the corner and your friends have sent an insane Airbnb down in Panama City Beach. You are way too ready for a week in the sun playing beer die, tanning, and hanging out with your closest friends, but the cost stops you in your tracks. You realize you need to make some quick money before heading down south and decide to sell Green Beer Day merch Uptown to pocket some quick change.
You purchase a basic printing press for $10 and a multitude of different sized T-shirts to begin your mini business. You want to take a deep dive into your costs because it’ll help you decide how much to charge in order to make enough to go on the wildest spring break yet.
Identifying the different costs
Let’s start with the 3 main costs types:
Fixed costs (FC) are costs that don't change with amount produced.
In the context of your business, your printing press is your fixed cost at $10. No matter how many units you produce your fixed cost will always be $10 because you just need one printer for all of your orders.
Variable costs (VC) are costs that do change with amount produced.
In the context of your business, as you make a new shirt you must purchase each factory unit at the same price. Thus, as you make more shirts, your overall variable costs rise.
Total costs (TC) are your fixed costs plus your variable costs.
These costs are pretty simple to understand. However, there is one more crucial cost to understand...
Marginal cost explained
One of the most important costs you need to consider is how much your total cost will increase with each additional t-shirt you produce. This is defined as your marginal cost.
Your marginal cost (MC) is the additional cost of each unit of output in relation to your total cost.
Marginal cost determines the best way to allocate resources to maximize output. Producing only 1 unit with a lot of capital (i.e. printing presses) isn’t efficient. On the flip side, producing too many units than your capital can handle is also inefficient.
So... how can we use marginal cost to determine the best way to allocate resources?