Module 6 — Marginal Pricing and Economic Dispatch
Lesson 2 of 8
Marginal Cost
Learning objectives
By the end of this lesson you should be able to:
- Understand what economists mean by marginal cost.
- Distinguish between fixed costs, variable costs and marginal costs.
- Explain why electricity markets focus on short-run marginal costs.
- Understand why different technologies have different marginal costs.
- Recognise why low marginal cost does not necessarily imply low total cost.
- Appreciate why marginal cost became the foundation of wholesale electricity market design.
Introduction
In the previous lesson we learned that electricity generators are dispatched according to their marginal costs.
But what exactly is a marginal cost?
Imagine a bakery.
Suppose the bakery has already baked 1,000 loaves of bread today.
How much does it cost to bake one additional loaf?
The answer is not the cost of constructing the bakery.
Nor is it the cost of buying the ovens several years ago.
Instead, it is the additional ingredients, electricity and labour required to bake one more loaf.
Economists call this the marginal cost.
Exactly the same idea applies to electricity generation.
What is marginal cost?
Marginal cost is the additional cost of producing one more unit of output.
For electricity, this means:
The additional cost of producing one more megawatt-hour (MWh) of electricity.
Notice the emphasis on additional.
Marginal cost asks:
"If I increase production slightly, how much more will it cost?"
Fixed costs and variable costs
To understand marginal cost, we first need to distinguish between different types of cost.
Fixed costs
These do not depend on how much electricity is generated.
Examples include:
- constructing a power station,
- financing,
- insurance,
- administration,
- many maintenance costs.
Whether a generator produces electricity today or remains idle, many fixed costs still exist.
Variable costs
Variable costs increase as electricity generation increases.
Examples include:
- fuel,
- emissions charges,
- consumable materials,
- additional wear and tear.
Variable costs depend directly upon electricity production.
Marginal costs
Marginal cost is the additional variable cost of producing one extra unit of electricity.
For many generators, fuel is the largest component.
A simple example
Imagine a gas-fired power station.
Suppose producing:
100 MWh
costs:
£5,000.
Producing:
101 MWh
costs:
£5,050.
The marginal cost of the final megawatt-hour is:
£50/MWh.
This does not mean every unit cost £50.
It simply means the next unit costs £50.
Why construction costs don't matter today
Imagine two identical gas power stations.
One was built twenty years ago.
The other opened yesterday.
The new station may have cost billions of pounds to construct.
The older station has long since recovered much of its investment.
Should today's dispatch depend on these historical costs?
Economists generally answer:
No.
Construction costs have already been incurred.
These are known as sunk costs.
Since they cannot be changed by today's operating decisions, they should not influence today's dispatch.
Instead, dispatch should minimise today's operating costs.
Marginal costs differ between technologies
Different generation technologies have very different marginal costs.
For example:
| Technology | Typical Marginal Cost |
|---|---|
| Wind | Very low |
| Solar | Very low |
| Nuclear | Low |
| Hydroelectric | Low to moderate |
| Coal | Moderate to high |
| Gas | Moderate to high |
| Diesel | Very high |
The largest reason for these differences is fuel.
Wind and solar require no purchased fuel.
Gas and coal consume fuel every time they generate electricity.
Diesel is often reserved for emergencies because its operating costs are particularly high.
Fuel costs
Fuel prices can change dramatically.
Suppose natural gas prices double.
Gas-fired electricity immediately becomes more expensive.
The marginal cost of gas generation rises.
Gas generators therefore move further up the merit order.
Exactly the same generator can occupy a different position in the market simply because fuel prices have changed.
Carbon pricing
Many countries place a price on carbon emissions.
This increases the operating costs of fossil-fuel generators.
For example:
A coal-fired power station emitting large amounts of carbon dioxide may pay significantly more than a wind farm emitting none.
Carbon pricing therefore changes marginal costs and influences dispatch decisions.
Low marginal cost does not mean cheap electricity
One of the most common misunderstandings is that low marginal cost means a technology is inexpensive overall.
This is not necessarily true.
Consider offshore wind.
Its marginal cost is extremely low because no fuel is required.
However:
- turbines are expensive,
- foundations are expensive,
- offshore cables are expensive,
- financing is expensive.
Most costs occur before the first unit of electricity is generated.
Marginal cost therefore tells us how expensive it is to operate a generator—not how expensive it was to build.
Short run versus long run
Economists distinguish between two different time horizons.
Short run
The generating fleet already exists.
The objective is simply to decide which generators should operate today.
Marginal costs dominate these decisions.
Long run
Society decides:
- which power stations to build,
- where to build them,
- how much capacity to install.
In the long run, construction costs become critically important.
Marginal cost alone cannot determine long-term investment decisions.
Why marginal cost became important
Electricity markets were designed primarily to solve the short-run dispatch problem.
Given today's generators:
How should they be operated?
Marginal costs provide an elegant answer.
Dispatch the available generators capable of producing the next unit of electricity most cheaply.
This minimises operating costs while meeting demand.
For many years this was regarded as one of the great successes of electricity market design.
Looking ahead
Understanding marginal cost explains which generators should operate.
It does not explain how much they should be paid.
Suppose a gas generator costing £80/MWh is required to meet demand.
Should every generator receive:
- its own operating cost?
Or should everyone receive the same market price?
This question leads directly to one of the defining features of modern electricity markets.
A key insight
Marginal cost measures the additional cost of producing one more unit of electricity.
Because construction costs cannot be changed in the short run, electricity markets dispatch generators according to their marginal costs rather than their total costs.
This minimises the short-run operating cost of supplying electricity.
However, dispatch and investment are fundamentally different problems.
Marginal cost provides an excellent guide for operating today's electricity system, but it says much less about how tomorrow's electricity system should be built.
Key takeaways
- Marginal cost is the additional cost of producing one more unit of electricity.
- Electricity markets distinguish between fixed costs, variable costs and marginal costs.
- Dispatch decisions focus on short-run marginal costs because construction costs are already sunk.
- Different technologies have different marginal costs, largely due to differences in fuel costs.
- Carbon prices can increase the marginal costs of fossil-fuel generation.
- Low marginal cost does not necessarily imply low total cost.
- Marginal cost is well suited to short-run dispatch but does not determine long-term investment decisions.
Looking ahead
If generators are dispatched according to their marginal costs, the next question is:
How should they be paid?
In the next lesson, we examine uniform marginal pricing, the pricing rule used by many wholesale electricity markets around the world.