Since resources are scarce we can not attain everything that we wish to, hence choices must be done. Every time we make choices we have to forego something, as the concept of opportunity cost tells us. “Marginal analysis is applied to help its user in utilizing their scarce resources to optimize the benefits accruing from their output” (Mankiw, 2000). This technique is widely used in decision-making processes by managers. Resource allocation decisions are made by comparing the marginal or incremental benefit of the change in the level of activity with the marginal cost of the change. In most cases, profit maximization firms usually use the concepts of marginal revenue and marginal costs when allocating resources.
Marginal cost and total cost
Marginal revenue is the additional cost as a result of an additional one unit of output. That is, marginal cost is the price of producing an extra unit of output. For example, if the cost of making six pieces of doughnuts is $ 5 and making seven costs $8, then the marginal cost of producing the seventh piece of doughnuts is $ 3. Mathematically marginal cost is expressed as MC = ∂TC/∂Q. The analysis of marginal cost is divided into short-run and long-run marginal costs. “Marginal cost only includes all cost that changes with level production and other cost are regarded as fixed in any level of production” (Jeffrey, 1999). Marginal cost increases with increases in production. This is so because as the firm’s output grows there are additional costs associated with the additional units of output. In general marginal cost determines how much the total revenue will increase if one more unit of output is produced.
Marginal revenue and total revenue
Marginal revenue is the additional revenue received when an additional unit of output is produced. It can also be defined as the change in total revenue as a result of a change in the quantity of output. If the revenue generated by selling five cars is the US $ 4 million and revenue generated for six cars is the US $ 4.5 million, the marginal revenue of the sixth car is US $ 0.5 million. It determines how much total revenue increases or decreases as one unit of product is added. Mathematically it is expressed as, MR=∂TR/∂Q
Profit is the net benefit of being in a business or the price of entrepreneurship. “An economic profit is an increase in assets of an investor resulting from the investment he or she makes considering all the cost related to that investment” (Lebedev, 2007 p, 220).
The objective of a firm is to maximize profit at sometimes reducing cost. Profit maximization is a method used by investors to determine at what price and output level investment returns will be highest There are two approaches in profit maximization: one, profit equals total revenue minus the total cost, and secondly, total profit in a perfectly competitive market is realized when marginal revenue equals marginal cost. A firm’s total cost can be split into fixed costs and variable costs. Fixed costs are those costs incurred by the firm at all levels of output, including when it has not started producing while variable costs are those cost which varies with additional one unit of output.
The total cost-total revenue method assumes that profit (∏) equals total revenue (TR) minus total cost (TC). That is, ∏ = TR-TC. Given figures of total revenue and total cost for each level of output, we can determine the profit-maximizing output by just getting the level of output at which the profit is highest. This simple profit-maximizing model of the firm provides decision-makers with useful insights regarding efficient resource management and allocation. However, the model is limited because it does not incorporate the type of decision in the decision-making process and it does not consider risks.
Another method used to find the profit-maximizing output level is the marginal cost-marginal revenue. “In each output level, marginal profit equals marginal revenue minus marginal cost.” When marginal revenue is higher than the marginal cost the marginal profit has a positive figure while if the marginal cost exceeds marginal revenue, the marginal profit will be negative. If MC=MR, then, marginal profit will be nil. Since marginal profit increases when marginal profit is positive and decreases when marginal profit is negative then maximum marginal revenue is reached when it’s nil, that is when marginal cost equals marginal revenue. Hence, the profit-maximizing level of output will be reached when marginal revenue equals marginal cost.
A profit maximization firm will continue to produce more output as long as the marginal revenue is higher than the marginal cost because it is making positive marginal profits. It will do so until marginal revenue equals marginal cost when profit is maximized. This is because any further production beyond this level of output will result in negative marginal profit as marginal cost exceeds marginal revenue. If marginal revenue is less than marginal cost, the firm must cut on production because any additional output proofs unprofitable to the firm (does not add to profit) since marginal profit will be negative. In a competitive market firm’s marginal revenue function is equal to market price, therefore if MR<MC, then the good is sold at price lower than its cost incurred to bring it into the market.
- Jeffrey D. Sachs, Wen-Li Chen, and Xiaokai Yang, (1999). An Infra-marginal Analysis of the Ricardian Model.
- Lebedev, Makushenko, (2007). Profit maximization and risk minimization in semi- Markovian networks. Cybernetics and Systems Analysis, Vol. 43, No. 2. pp. 213- 224.
- Mankiw, N. Gregory, (2000). Principles of Microeconomics. South-Western Publishers.