Marginal cost and average cost are two measures in microeconomics, which focuses on an individual entity's economic situation. Both deal with the cost of producing a certain number of units. When a measure is modified by the word “marginal,” it refers to the cost of “one extra” of something. Average is just the aggregate mean.
MC is one of the most important microeconomic measures. It is central to the determination of profit margins. MC is the cost for producing “one more” of something. Given a certain amount of machinery, labor and demand, there is a optimal number of goods to be produced. Making less than the optimal number will drive the price upward, since demand will not be satisfied. Making more than the optimal number will drive profits down, since the market will be oversaturated.
The Importance of MC
MC is tightly bound with the law of diminishing returns. This law is easy to digest because it is something experienced every day. There is always “too much” of something, and that excess can be harmful. If a firm is making profits from producing 100 units a day, it is a logical fallacy to hold that more profits will be made at 101 units or 1,000 units. MC holds that, given your capital stock and labor, it will cost more to produce additional units over the optimum. If your capital stock and labor are working at their maximum, adding more units of production will overload the system, making each new product expensive relative to your first 100 units. At the same time, if your market is satisfied at 100 units, adding anther unit will diminish profits because of oversupply, forcing down all prices of that product. Therefore, marginal cost calculations are essential to working out a rational production schedule.
Average cost is figured like any other average: take the total cost of production, and divide the number of total goods produced into it. The entire purpose of MC is to deal with the problems of AC. AC does not utilize important production variables. AC only takes the mean of all units of production, regardless of their rationality. MC becomes a measure of rational production since it shows where your production limit is, and the costs of exceeding it.
Like marginal costs and diminishing returns, utility is the purpose for your production. Utility refers to the “use” of a thing, or the amount of extra profit you get from selling additional units. For example, you produce and distill whiskey. It costs $100 to get a full truckload of rye to your distillery. This makes 50 bottles. If you want to make 51 bottles, you'll need another truckload. This, however, is irrational since you only want one additional bottle, yet, given your supplier's mode of operation, it is only worth it to the supplier to send another full truckload. Therefore, the marginal cost of that extra bottle is huge, and therefore, your marginal utility of selling that extra bottle is negative, since you lose money.