Economists divide a producer’s costs into fixed costs and variable costs. A fixed cost is a cost that does not change, no matter how much is produced. Examples of fixed costs include rent and machinery repairs. A variable cost is a cost that rises or falls depending on the quantity produced. These include the costs of raw materials and some labor. Fixed and variable costs are added together to find total cost.

     Businesses can increase output by hiring more workers or purchasing more capital. The change in output from adding one more worker is the marginal product of labor. At the beginning, adding each worker will result in increasing marginal returns. Workers will be able to specialize and gain skills. At some point, adding each worker will result in diminishing marginal returns. Workers may need to wait to use a tool or machine. As more workers are added, there will eventually be negative marginal returns.

     Marginal cost is the cost of producing one more unit of a good. Marginal revenue is the revenue gained from producing one more unit of a good—usually, the price of a unit. When marginal cost is less than marginal revenue, a producer has an incentive to increase output, since it will earn a profit on the next unit produced. When marginal cost is more than marginal revenue, a producer has an incentive to decrease output, since it will lose money on the next unit produced. That is why profits are maximized when marginal cost equals marginal revenue.