Why does marginal cost increase?
The best way to answer the question is by way of example. Imagine that a municipal water authority (“the water company”) started out by serving a small city. A production capacity of 500 AF/day was sufficient to serve the city’s population. However, over time the population grew and spread into the surrounding suburbs. So to serve the growing suburban population, the water company has gradually expanded its production capacity to 1500. When the water company was supplying only the city, the cost of producing an additional acre-foot of water was only $25. The reason for the low cost is that homes and businesses in a city tend to be packed close together. Therefore, it takes only a small amount of extra pipe and pumping power to bring water service to additional city customers.
