Marginal cost is the additional cost incurred by a firm when it produces one more unit of a good or service. It's derived from the change in total variable costs, which increase with the production level. Examples include the expenses for raw materials and labor.

For example, let's consider a bakery that produces cakes. The variable costs for each cake include ingredients like flour, sugar, and eggs, as well as labor costs for the baker's time. If the bakery decides to increase production and bake one more cake, it incurs additional variable costs for the extra ingredients and labor required. The marginal cost would represent the increase in total variable costs divided by the increase in the number of cakes produced.

Understanding marginal cost helps businesses determine the most efficient level of production. If the marginal cost is lower than the selling price of the cakes, the bakery can increase production to maximize profits. However, if the marginal cost exceeds the selling price, producing more cakes would result in incurring losses, indicating that the bakery should scale back production. Therefore, analyzing marginal cost enables firms to optimize their production processes and make strategic decisions to enhance profitability.