A lower price would flatten the total revenue curve, meaning that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses.
However, a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest. The approach that we described in the previous section, using total revenue and total cost, is not the only approach to determining the profit maximizing level of output. In this section, we provide an alternative approach which uses marginal revenue and marginal cost.
Firms often do not have the necessary data they need to draw a complete total cost curve for all levels of production. They cannot be sure of what total costs would look like if they, say, doubled production or cut production in half, because they have not tried it. Instead, firms experiment. They produce a slightly greater or lower quantity and observe how it affects profits.
In economic terms, this practical approach to maximizing profits means examining how changes in production affect revenues and costs. In the module on production and dosts, we introduced the concept of marginal cost—the change in total cost from producing one more unit of output.
Similarly, we can define marginal revenue as the change in total revenue from selling one more unit of output. Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by exactly the same amount equal to the market price.
This condition only holds for price taking firms in perfect competition where:. Notice that marginal revenue does not change as the firm produces more output. That is because the price is determined by supply and demand and does not change as the farmer produces more keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined.
Figure 2. Market Price. Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes at the market-determined price. Marginal cost, the cost per additional unit sold, is calculated by dividing the change in total cost by the change in quantity. The formula for marginal cost is:. Unlike marginal revenue, ordinarily, marginal cost changes as the firm produces a greater quantity of output.
At first, marginal cost decreases with additional output, but then it increases with additional output. Again, note this is the same as we found in the module on production and costs. Table 3 presents the marginal revenue and marginal costs based on the total revenue and total cost amounts introduced earlier. The marginal revenue curve shows the additional revenue gained from selling one more unit, as shown in Figure 3. The firm should continue to raise produce extra units of output as long as the marginal revenue it receives from that unit exceeds the marginal cost.
Answered by Cassandra Cristiana I. Need help with Maths? One to one online tuition can be a great way to brush up on your Maths knowledge. Answered by Sarah K. Therefore firms may decide to make less than maximum profits and pursue a higher market share.
I have a question.. Thank you so much for your very clear explination of this concept I found it really helpful for my assignment. Products conditions really matter in determining the price of the commodity. Favourable condition will attract best price for the commodity.
Due to product differentiation, MC price increase at costs increase. What should an MC firm do to maximize profit? Minimize differentiation of products b. Absorb the cost of differentiation, minimizing profit c. All of the choices d. Select a combination of price, quality and product differentiation that will maximize profit. Save my name and email in this browser for the next time I comment. Profit Maximization Example In the early s 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.
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. Competition The use of the profit maximization rule also depends on how other firms react.
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