David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

6.6 Marginal cost and marginal revenue
Marginal cost is large when output is low, but also when output is high. Marginal cost is lowest when making
the fourth unit, which adds only £7 to total costs.
As output increases, why do marginal costs start high, then fall, then rise again? The answer reflects
different production techniques. At low output, the firm uses simple techniques. As output rises, more
sophisticated machines are used, making extra output quite cheap. As output rises still further, the
difficulties of managing a large firm emerge. Raising output gets hard and marginal costs rise.
Figure 6.1 plots this relation between output and marginal cost. The marginal cost curve can be different
from firm to firm. In a coal mine that is nearly worked out, marginal cost rises steeply with extra output.
In mass-production industries, as output increases marginal cost may decline and then become constant
(see Figure 6.1 again).
Margi na I costs in practice: the case of the water
industry in the UK
In reality, calculating marginal costs for a firm is not that straightforward. To do so, we need to have an idea
of what the firm's total costs look like and of how that total cost is related to the output produced. In practice,
we need to estimate how the total costs change and output is increased or decreased.
Water suppliers are normally large and complicated firms. Working out the relationship between output
produced (water supply and services) and total costs is not straightforward. In the UK, water companies are
regulated by Ofwat, the water service regulation authority.*
Ofwat needs to control the behaviour of water companies and to try to ensure that those companies behave
as efficiently as possible. More efficient firms should have lower marginal costs of production. Therefore,
getting estimates of marginal costs for those companies is important for Ofwat.
The main costs that water companies incur are related to the use of resources (the inputs used in production),
treatment of water, bulk transportation and local distribution. The following table lists estimates for the
marginal costs of different water companies made by Ofwat. All the marginal costs are measured as prices
(as measured in November 2002) per cubic metre.
Resources Treatment Bulk transport Local distribution Total marginal cost
Company (p/m 3 ) (p/m 3 ) (p/m 3 ) (p/m 3 ) (p/m 3 )
Ang lion 16 12 15 1 45
Northumbrion 1 1 5 28 13 58
Severn Trent
13 15
15 15 58
Thomes 42 3 2 1 49
Wessex 12 12
25
75 125
Source: Ofwat, Tariff Structure and Charges: 2003-2004 Report (www.ofwat.gov.uk/regulating/reporting/rpt_tar2003-04.pdf) .
Separate estimates of marginal costs are made by increment: 'resources: 'treatment: 'bulk transport' and 'local
distributiod. The sum of these increment costs yields the total marginal cost. Total marginal cost figures may
not add up due to rounding. The table tells us that, if Anglian wants to increase its production by 1 cubic
metre of water, the change in its total cost is going to be £45. Notice that, even if water companies produce
a similar good (water and related services), there is some variation in the marginal costs they face.
*
Regulation will be discussed in more detail in Chapter 8.
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