What is the relationship between marginal cost and supply?
In economics, marginal cost is the additional cost associated with producing an additional unit of a product. Companies rely on this information to help them make decisions regarding pricing and production targets. In a purely competitive market, marginal cost and supply will always be the same. Graphically, marginal cost and supply can be illustrated by the same rising cost curve, and they overlap at each price point. However, in a market that is not perfectly competitive, the relationship between marginal cost and supply changes and the two values are no longer equal.
As price levels rise, so does the amount of goods and services firms produce. For example, a company that manufactures cars will sell a certain number of units at one price, but if the market price increases, the company will manufacture more cars to maximize profits. The reverse is also true, resulting in decreased output as market prices fall.
This same type of relationship can also be observed when looking at marginal cost, albeit for different reasons. The law of diminishing returns states that as firms increase the resources needed to increase production, marginal cost will decrease, bottom out, and begin to increase. To understand why, consider a car factory with 100 workers. Adding 25 more workers can help increase production and reduce the marginal cost of each new car. However, if the company added 100 more workers, those employees would start to slow each other down or get in the way of each other, resulting in an increase in marginal cost.
From this example, you can see that as the supply increases, the price automatically increases as well. In a perfectly competitive market, firms will set production rates at the exact point where price equals marginal cost. By doing so, they can reap maximum benefits and efficiency. Since the price is constantly fluctuating due to natural market forces, production or supply rates will also continually change. This relationship between marginal cost and supply holds at all price points and continues to hold as the price fluctuates.
In a market that is not perfectly competitive, this relationship between marginal cost and supply is no longer valid. For example, a company that has a market monopoly does not need to respond to price changes because it can set prices for a product. In this type of market, the company determines production rates based on demand rather than marginal cost.