What will happen when Mr exceeds MC at any level of output?

The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.

Profit Maximization Formula

The profit maximization rule formula is


Marginal Cost is the increase in cost by producing one more unit of the good.

Marginal Revenue is the change in total revenue as a result of changing the rate of sales by one unit. Marginal Revenue is also the slope of Total Revenue.

Profit = Total Revenue – Total Costs

Therefore, profit maximization occurs at the most significant gap or the biggest difference between the total revenue and the total cost.

Why is the output chosen at MC = MR?

What will happen when Mr exceeds MC at any level of output?

At A, Marginal Cost < Marginal Revenue, then for each additional unit produced, revenue will be higher than the cost so that you will generate more.

At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be higher than revenue so that you will create less.

Thus, optimal quantity produced should be at MC = MR

Application of Marginal Cost = Marginal Revenue

The MC = MR rule is quite versatile so that firms can apply the rule to many other decisions.

For example, you can apply it to hours of operation. You decide to stay open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.

Or it can be applied to advertising. You should increase the number of times you run your TV commercial as long as the added revenue from running it one more time outweighs the added cost of running it one more time.

Profit Maximization Example

In the early 1960s and before, airlines typically decided to fly additional routes by asking whether the extra revenue from a flight (the Marginal Revenue) was higher than the per-flight cost of the flight.

In other words, they used the rule Marginal Revenue = Total Cost/quantity

Then Continental Airlines broke from the norm and started running flights even when the added revenues were below average cost. The other airlines thought Continental was crazy – but Continental made huge profits.

Eventually, the other carriers followed suit. The per-flight cost consists of variable costs, including jet fuel and pilot salaries, and those are very relevant to the decision about whether to run another flight.

However, the per-flight cost also includes expenditures like rental of terminal space, general and administrative costs, and so on. These costs do not change with an increase in the number of flights, and therefore are irrelevant to that decision.

Limitations of the Profit Maximization Rule (MC = MR)

What will happen when Mr exceeds MC at any level of output?

1. Real World Data

In the real world, it is not so easy to know exactly your Marginal Revenue and Marginal Cost of the last products sold. For example, it is difficult for firms to know the price elasticity of demand for their goods – which determines the MR.

2. Competition

The use of the profit maximization rule also depends on how other firms react. If you increase your price, and other firms may follow, demand may be inelastic. But, if you are the only firm to increase the price, demand will be elastic.

3. Demand Factors

It is difficult to isolate the effect of changing the price on demand. Demand may change due to many other factors apart from price.

4. Barriers to Entry

Increasing prices to maximize profits in the short run could encourage more firms to enter the market. Therefore firms may decide to make less than maximum profits and pursue a higher market share.

Similar Posts:

  • Perfect Competition
  • Price Elasticity of Demand (PED)
  • Oligopoly Market Structure
  • Theory of Production: Cost Theory
  • Economies of Scale

The marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of a product that will maximize profits.

A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point at which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.

  • When it comes to operating a business, overall profits and losses matter, but what happens on the margin is crucial.
  • This means looking at the additional cost versus revenue incurred by producing just one more unit.
  • According to economic theory, a firm should expand production until the point where marginal cost is equal to marginal revenue.

Production costs include every expense associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.

Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries and wages, building rental payments, or utility costs. Variable costs, meanwhile, are those directly related to and those that vary with production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production.

Total production costs include all the expenses of producing products at current levels. As an example, a company that makes 150 widgets has production costs for all 150 units it produces. The marginal cost of production is the cost of producing one additional unit.

For instance, say the total cost of producing 100 units of a good is $200. The total cost of producing 101 units is $204. The average cost of producing 100 units is $2, or $200 ÷ 100. However, the marginal cost for producing unit 101 is $4, or ($204 - $200) ÷ (101-100).

At some point, the company reaches its optimum production level, the point at which producing any more units would increase the per-unit production cost. In other words, additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level may involve paying prohibitively high amounts of overtime pay to workers. Alternatively, the maintenance costs for machinery may significantly increase.

The marginal cost of production measures the change in the total cost of a good that arises from producing one additional unit of that good.

The marginal cost (MC) is computed by dividing the change (Δ) in the total cost (C) by the change in quantity (Q). Using calculus, the marginal cost is calculated by taking the first derivative of the total cost function with respect to the quantity:

M C = Δ C Δ Q where: M C = Marginal cost Δ = Dividing the change C = Total cost Q = Change in quantity \begin{aligned}&MC=\frac{\Delta C}{\Delta Q}\\&\textbf{where:}\\&MC=\text{Marginal cost}\\&\Delta=\text{Dividing the change}\\&C=\text{Total cost}\\&Q=\text{Change in quantity}\end{aligned} MC=ΔQΔCwhere:MC=Marginal costΔ=Dividing the changeC=Total costQ=Change in quantity

The marginal costs of production may change as production capacity changes. If, for example, increasing production from 200 to 201 units per day requires a small business to purchase additional equipment, then the marginal cost of production may be very high. In contrast, this expense might be significantly lower if the business is considering an increase from 150 to 151 units using existing equipment.

A lower marginal cost of production means that the business is operating with lower fixed costs at a particular production volume. If the marginal cost of production is high, then the cost of increasing production volume is also high and increasing production may not be in the business's best interests.

Marginal revenue measures the change in the revenue when one additional unit of a product is sold. Assume that a company sells widgets for unit sales of $10, sells an average of 10 widgets a month, and earns $100 over that timeframe. Widgets become very popular, and the same company can now sell 11 widgets for $10 each for a monthly revenue of $110. Therefore, the marginal revenue for the 11th widget is $10.

The marginal revenue is calculated by dividing the change in the total revenue by the change in the quantity. In calculus terms, the marginal revenue (MR) is the first derivative of the total revenue (TR) function with respect to the quantity:

M R = Δ T R Δ Q where: M R = Marginal revenue Δ = Dividing the change T R = Total revenue Q = Change in quantity \begin{aligned}&MR=\frac{\Delta TR}{\Delta Q}\\&\textbf{where:}\\&MR=\text{Marginal revenue}\\&\Delta=\text{Dividing the change}\\&TR=\text{Total revenue}\\&Q=\text{Change in quantity}\end{aligned} MR=ΔQΔTRwhere:MR=Marginal revenueΔ=Dividing the changeTR=Total revenueQ=Change in quantity

For example, suppose the price of a product is $10 and a company produces 20 units per day. The total revenue is calculated by multiplying the price by the quantity produced. In this case, the total revenue is $200, or $10 x 20. The total revenue from producing 21 units is $205. The marginal revenue is calculated as $5, or ($205 - $200) ÷ (21-20).

Marginal revenue increases whenever the revenue received from producing one additional unit of a good grows faster—or shrinks more slowly—than its marginal cost of production. Increasing marginal revenue is a sign that the company is producing too little relative to consumer demand, and that there are profit opportunities if production expands.

Let's say a company manufactures toy soldiers. After some production, it costs the company $5 in materials and labor to create its 100th toy soldier. That 100th toy soldier sells for $15, meaning the profit for this toy is $10. Now, suppose the 101st toy soldier also costs $5, but this time can sell for $17. The profit for the 101st toy soldier, $12, is greater than the profit for the 100th toy soldier. This is an example of increasing marginal revenue.

For any given amount of consumer demand, marginal revenue tends to decrease as production increases. In equilibrium, marginal revenue equals marginal costs; there is no economic profit in equilibrium. Markets never reach equilibrium in the real world; they only tend toward a dynamically changing equilibrium. As in the example above, marginal revenue may increase because consumer demands have shifted and bid up the price of a good or service.

It could also be that marginal costs are lower than they were before. Marginal costs decrease whenever the marginal revenue product of labor increases—workers become more skilled, new production techniques are adopted, or changes in technology and capital goods increase output.

When marginal revenue and the marginal cost of production are equal, profit is maximized at that level of output and price:

M R = Δ T R Δ Q M C = Δ C Δ Q E q . = M R = M C \begin{aligned}MR&=\frac{\Delta TR}{\Delta Q}\\\\[-9pt]MC&=\frac{\Delta C}{\Delta Q}\\\\[-9pt]Eq.&=MR=MC\end{aligned} MRMCEq.=ΔQΔTR=ΔQΔC=MR=MC

For instance, a toy company can sell 15 toys at $10 each. However, if the company sells 16 units, the selling price falls to $9.50 each. The marginal revenue is $2, or ((16 x 9.50) - (15 x10)) ÷ (16-15). Suppose the marginal cost is $2.00; the company maximizes its profit at this point because the marginal revenue is equal to its marginal cost.

When marginal revenue is less than the marginal cost of production, a company is producing too much and should decrease its quantity supplied until marginal revenue equals the marginal cost of production. When, on the other hand, the marginal revenue is greater than the marginal cost, the company is not producing enough goods and should increase its output until profit is maximized.

When expected marginal revenue begins to fall, a company should take a closer look at the cause. The catalyst could be market saturation or price wars with competitors.

If this is the case, the company should plan for this by allocating money to research and development (R&D), so it can keep its product line fresh. Should a company believe it will be unable to increase its marginal revenue once it's expected to decline, management will need to look at both its marginal revenue and the marginal cost of producing an additional unit of its good or service, and plan on maintaining sales volume at the point where they intersect.

If the company plans on increasing its volume past that point, each additional unit of its good or service will come at a loss and shouldn't be produced.

Although they sound similar, marginal revenue is not the same as a marginal benefit. In fact, it's the flip side. While marginal revenue measures the additional revenue a company earns by selling one additional unit of its good or service, marginal benefit measures the consumer's benefit of consuming an additional unit of a good or service.

Marginal benefit represents the incremental increase in the benefit to a consumer brought on by consuming one additional unit of a good or service. It normally declines as more of a good or service is consumed.

For example, consider a consumer who wants to buy a new dining room table. They go to a local furniture store and purchase a table for $100. Since they only have one dining room, they wouldn't need or want to purchase a second table for $100. They might, however, be enticed to purchase a second table for $50, since there is an incredible value at that price. Therefore, the marginal benefit to the consumer decreases from $100 to $50 with the additional unit of the dining room table.

Tying the two together, let's go back to our widget-maker example. Let's say a customer is contemplating buying 10 widgets. If the marginal benefit of purchasing the 11th widget is $3, and the widget company is willing to sell the 11th widget to maximize its consumer benefit, the marginal revenue to the company would be $3 and the marginal benefit to the consumer would be $3.

All these calculations are part of a technique called marginal analysis, which breaks down inputs into measurable units. First developed by economists in the 1870s, it gradually became part of business management, especially in the application of the cost-benefit method—the identification of when marginal revenue is greater than marginal cost, as we've been explaining above.

According to the cost-benefit analysis, a company should continue to increase production until marginal revenue is equal to marginal cost. If the optimal output is where the marginal benefit is equal to marginal cost, any other cost is irrelevant. So marginal analysis also tells managers what not to consider when making decisions about future resource allocation: They should ignore average costs, fixed costs, and sunk costs.

For example, a toy manufacturer could try to measure and compare the costs of producing one extra toy with the projected revenue from its sale. Suppose that, on average, it has cost the company $10 to make a toy. The average sales price over the same period is $15.

This doesn't necessarily mean that more toys should be manufactured, however. If 1,000 toys were previously manufactured, then the company should only consider the cost and benefit of the 1,001st toy. If it will cost $12.50 to make the 1,001st toy, but will only sell for $12.49, the company should stop production at 1,000.

Manufacturing companies monitor marginal production costs and marginal revenues to determine ideal production levels. The marginal cost of production is calculated whenever productivity levels change. This allows businesses to determine a profit margin and make plans for becoming more competitive to improve profitability.

The best entrepreneurs and business leaders understand, anticipate, and react quickly to changes in marginal revenues and costs. This is an important component in corporate governance and revenue cycle management.