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7
Output, Price, and Profit:
The Importance of
Marginal Analysis
Business is a good game . . .You keep
score with money.
NOLAN BUSHNELL, FOUNDER OF ATARI
Contents
● Price and Quantity: One Decision, Not Two
● Total Profit: Keep your Eye on the Goal
● Marginal Analysis and Maximization of
Total Profit
● Generalization: The Logic of Marginal
Analysis and Maximization
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Contents (continued)
● Conclusion: The Fundamental Role of
Marginal Analysis
● The Theory and Reality: A Word of
Caution
● Appendix: The Relationships Among Total,
Average, and Marginal Data
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Price and Quantity: One
Decision, Not Two
● Firms face a demand curve on which price
and quantity are related.
● They can choose either price or quantity, but
not both.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-1 Demand Curve for
Al’s Garages
Price per Garage (thousands $)
FIGURE
35
30
26
19
16
Da
b
c
d
25
22
20
e
Profit maximum
f
g
h
i
15
j
D
10
5
0
1
2
3
4
5
6
7
8
9
10
Output, Garages Marketed per Year
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Total Profit: Keep Your Eye
on the Goal
● Simplifying assumption: maximum total
profit is the firm’s goal.
● Total profit = total revenue - total costs
● Economic profit  accounting profit
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Total Profit: Keep Your Eye
on the Goal
● Total, Average, and Marginal Revenue
♦ Total Revenue = P  Q
♦ Average Revenue = TR/Q = (P  Q)/Q = P
♦ Marginal Revenue =  total revenue from one
more unit of output.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-1 Demand for Al’s
Garages
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-2 Total Revenue Curve
for Al’s Garages
Total Revenue per Year (thousands $)
FIGURE
140
F
120
G
H
I
J
TR
E
D
100
C
80
B
60
40
A
20
0
1
2
3
4
5
6
7
8
9
10
Output, Garages Sold per Year
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Total Profit: Keep Your Eye
on the Goal
● Total, Average, and Marginal Cost
♦ The shapes of the cost curves mean that there is
some size for the firm that is most efficient.
♦ Firms that are smaller or larger than this
optimal size will have higher average costs.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-2 Al’s Total, Average,
and Marginal Costs
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-3 (a) Cost Curves for
Al’s Garages
FIGURE
200
TC
Total Cost per Year (thousands $)
180
160
140
120
100
80
60
40
20
0
1
2
3
4
5
6
7
8
Output, Garages per Year
(a) Total Cost
9
10
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-3 (b) Cost Curves for
Al’s Garages
FIGURE
Average Cost per Garage (thousands $)
45
40
35
30
25
AC
20
15
10
5
0
1
2
3
4
5
6
7
8
9
10
Output, Garages per Year
(b) Average Cost
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-3 (c) Cost Curves for
Al’s Garages
Marginal Cost per Added Garage (thousands $)
FIGURE
50
MC
45
40
35
30
25
20
15
10
5
0
1
2
3
4
5
6
7
8
Output, Garages per Year
(c) Marginal Cost
9
10
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Total Profit: Keep Your Eye
on the Goal
● Maximization of Total Profits
♦ Profits typically increase with output, then fall.
♦ Some intermediate level of output, therefore,
generates the maximum profit.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-3 TR, Costs, and Profit
for Al’s Garages
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Marginal Analysis and
Maximization of Total Profit
● Marginal profit is the slope of the total
profit curve.
● Profit is at a maximum when the marginal
profit is zero.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-4 (a) Profit
Maximization
Total Revenue, Total Cost per Year (thousands $)
FIGURE
200
TC
180
160
140
TR
120
A
100
96
80
74
60
Profit
B
22,000
40
20
0
1
2
3
4
5
6
7
8
9
10
Output, Garages per Year
(a) Total Revenue. Total Cost
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-4 (b) Profit
Maximization
Total Profit per Year (thousands $)
FIGURE
40
34
20
Total profit
M
F
E
C
D
0
–20
1
2
3
4
5
6
7
8
9
10
–40
–60
–80
Output, Garages per Year
(b) Total Profit
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Marginal Analysis and
Maximization of Total Profit
● Optimum Marginal Revenue and Marginal
Cost
♦ If MR > MC,  production   profits
♦ If MR < MC,  production   profits
● Profit maximizing level out output: MR =
MC
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-4 Al’s Marginal Revenue
and Marginal Cost
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-5(a) Profit Maxim:
Another Graphical Interpretation
FIGURE
MR and MC per Garage per Year
(thousands $)
50
MC
40
30
20
E
10
0
1
2
3
4
5
6
7
8
9
10
MR
–10
Output, Garages per Year
(a) Marginal Revenue and Marginal Cost
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-5(b) Profit Maxim:
Another Graphical Interpretation
Total Revenue, Total Cost per Year (thousands $)
FIGURE
200
TC
180
160
140
TR
120
A
100
96
80
74
60
Profit
B
22,000
40
20
0
1
2
3
4
5
6
7
8
9
10
Output, Garages per Year
(a) Total Revenue. Total Cost
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-5(c) Profit Maxim:
Another Graphical Interpretation
Total Profit per Year (thousands $)
FIGURE
40
34
20
Total profit
M
F
E
C
D
0
–20
1
2
3
4
5
6
7
8
9
10
–40
–60
–80
Output, Garages per Year
(b) Total Profit
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Marginal Analysis and
Maximization of Total Profit
● Finding the Optimal Price from Optimal
Output
♦ MR = MC: rule for determining the level of
output
♦ Demand curve  price buyers will pay to
purchase that level of output
♦ Both output and price are now determined for
the profit maximizing firm.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Logic of Marginal Analysis &
Maximization
● If a decision is to be made about the
quantity of some variable, then maximize
net benefit.
● Net benefit = total benefit - total cost
● To maximize net benefit, select a value of
the variable at which marginal benefit =
marginal cost.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Logic of Marginal Analysis &
Maximization
● Application: Fixed Cost and Profit
Maximization
♦ An increase in fixed costs does not change
optimal output or price because it does not
affect marginal costs.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-5 Rise in Fixed Cost:
Total Profits Before and After
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
7-6 Fixed Cost Does Not
Affect Profit-Maximizing Output
Total Profit per Year
(thousands $)
FIGURE
Profit with zero
fixed cost
40
M
Profit with
a fixed cost
N
20
0
1
2
3
4
5
6
7
8
9
10
Output in Garages per Year
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
The Fundamental Role of
Marginal Analysis
● Marginal analysis can be used to illuminate
many everyday problems, in business and
elsewhere, sometimes with surprising
results.
● For example, a new activity will add to
profits if it more than covers its marginal
cost, not the fully allocated average cost.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
The Fundamental Role of
Marginal Analysis
● Any problem involving optimization can be
illuminated with marginal analysis.
● The logic of marginal analysis can be
applied to government, universities,
hospitals and other organizations as well as
businesses.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Theory and Reality: A Word
of Caution
● Business people seldom use marginal
analysis in a literal sense.
● They often rely on intuition and hunches.
● But these theories can be used to understand
and predict behavior.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Appendix:
Relationships Among
Total, Average, and
Marginal Data
Relationships Among Total,
Average, and Marginal Data
● Average = total  the number of units
● Total = average  the number of units
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Relationships Among Total,
Average, and Marginal Data
● Marginal value of the xth unit = total
value of x units - total value of (x - 1)
units.
● Total value of x units =  marginal values
of the first x units.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-6 Weights of Persons in
a Room (in pounds)
TABLE
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Relationships Among Total,
Average and Marginal Data
● The marginal, average and total values for
the first unit are usually equal.
♦ If marginal < average, the average is falling.
♦ If marginal > average, the average is rising.
♦ If marginal = average, the average is constant;
that is, the average is at a maximum or
minimum.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
7-7 Relationship between
Marginal and Average Curves
Marginal and Average Weight
(pounds)
FIGURE
B
150
100
E
C
A
D
F
Marginal
weight
50
0
Average
weight
1
2
3
4
5
6
Number of Persons
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.