Firm's cost structure
Marginal cost and Marginal revenue
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The manager of a firm wants to know what quantity to produce in order to maximise profits. To solve this problem, the manager needs one more cost concept: marginal cost.
Marginal cost is how much total costs increase when one more unit of output is produced.
The marginal cost of one more unit of output depends on how much output has already been produced.
At every level of output, it will be possible to calculate the marginal cost - the cost of producing one extra unit. A typical pattern would be that marginal cost will tend to fall up to a certain level so that it costs less and less to produce each extra unit, but then begins to rise.
Just as it is possible to calculate marginal cost, so the same can be done for revenue.
Marginal revenue is simply the extra revenue, at any point, from an additional sale.
Profit maximising output
How do you know how much to make to maximise profit? You stop increasing production when you are on the point of losing on any extra sales. You do not, in other words, sell anything at a loss. As long as the extra revenue from an additional sale exceeds the cost to you of generating that sale, carry on raising output. Once the extra revenue merely equals your additional cost - marginal revenue equals marginal cost — it is time to call a halt.
The firm wants to produce at the level of output where marginal revenue equals marginal cost (MR = MC).
Producing where MR = MC does two things:
It minimises the firm’s loss if it has to take a loss due to a low selling price for its output.
It maximises the firm’s profit if it can make a profit because the selling price is high enough.
The idea behind MR = MC is very simple and basically comes down to a cost versus benefit analysis. If producing and selling a product brings in more revenue than it costs to produce a product, produce it. If not, don’t produce it.