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Marginal Analysis in Economics

Introduction

Marginal analysis is a decision-making tool that helps individuals and organizations to choose actions that are associated with the greatest benefits. It helps in assessing the implications of changes in costs and benefits that are occasioned by changes in actions such as increasing production. This means that the decision to take a particular action should be considered if the additional cost associated with the action is less than the additional benefits (Boyes & Melvin, 2007). This paper explores marginal analysis as a concept in economics by focusing on marginal revenue, marginal cost and profit maximization.

Marginal Revenue and Total Revenue

Marginal revenue refers to the “extra revenue that accrues from selling an additional unit of a product” (Boyes & Melvin, 2007). Thus it is the extra income that a company receives by selling an extra unit of its goods.

The relationship between total revenue and marginal revenue is based on the fact that the later is derived from the former. If the total revenue function can be differentiated, then its first derivative is equal to the marginal revenue function. This is expressed as: MR = δTR/δQ, where TR refers to total revenue, MR refers to marginal revenue and Q refers to the quantity sold. This relationship means that marginal revenue is a measure of the gradient of the curve that describes the total revenue function (Boyes & Melvin, 2007). Therefore, marginal revenue is used to examine the effect of changes in sales on total revenue.

Marginal Cost and Total Cost

Marginal cost refers to the “change in total cost that arises when the quantity produced changes by one unit” (Boyes & Melvin, 2007). It consists of all the costs that a company has to incur in order to increase its output by one unit.

The marginal cost and total cost are related due to the fact that the former is derived from the later. Thus if the “total cost function is differentiable” (Boyes & Melvin, 2007), then the marginal cost function is expressed as: MC = δTC/δQ, where MC denotes marginal cost, TC denotes total cost and Q denotes the quantity produced. This means that the slope or the gradient of the curve that describes the TC function is measured by the marginal cost. The significance of this relationship is that marginal cost predicts the impact of changes in production volume on total cost.

Profit and Profit Maximization

Profit refers to the “difference between a firm’s total revenue and all costs including normal profits” (Boyes & Melvin, 2007). Normal profits in this case refers to the opportunity costs associated with a given business endeavor. Thus it refers to the return that accrues from a business venture.

Profit maximization relates to the process by which entrepreneurs determine the price and output level that leads to the highest possible profits. This can be done by using “marginal cost and marginal revenue approach or by using total cost and total revenue approach” (Boyes & Melvin, 2007). Profit is maximized when marginal cost is equivalent to marginal revenue. In order to maximize profits, the fixed costs and the variable costs must be controlled. This involves implementing strategies that leads to a reduction in both variable and fixed costs without affecting the quality of products in a negative manner.

Profit Maximization Using Marginal Revenue as well as Marginal Cost

This can be illustrated by the figure below

Profit Maximization Using Marginal Revenue as well as Marginal Cost

  • MC: marginal cost
  • ATC: average total cost
  • D: demand
  • AR: average revenue
  • MR: marginal revenue

The above figure refers to a firm that operates in a market that is characterized by a perfect competition. Thus its demand curve, D, is a “horizontal line and is equal to its marginal revenue and average revenue” (Boyes & Melvin, 2007). As discussed earlier, profit is maximized when MR= MC. This is based on the fact that marginal profit increases as long as marginal revenue is more than marginal cost. Thus the highest profit is obtained when marginal profit reduces to zero. Marginal profit reduces to zero when MR=MC. In the above figure, MR= MC at point A where the MR curve intersects the MC curve. Thus the maximum profit of the firm is represented by the area marked PCBA. This means that in order to realize maximum profits, the firm must produce Q units of goods and sell them at P dollars. Thus Q and P as shown in the figure are the optimum quantity and price respectively.

Action Taken when MR>MC

When the “marginal revenue is greater than marginal cost” (Boyes & Melvin, 2007), a profit maximizing firm should sell more units of its goods. This is because the firm will increase its total revenue by selling more units up to the level where marginal cost becomes equivalent to marginal revenue.

Action Taken when MR<MC

When the marginal revenue is less than the marginal cost, a firm is likely to make losses by increasing its output or sales (Boyes & Melvin, 2007). This means that a profit maximizing firm should stop producing more goods or selling more units of its goods when the marginal revenue is less than the marginal cost.

Reference

Boyes, W., & Melvin, M. (2007). Microeconomics. New York: Cengage Learning.