7 7 output, price, and profit: the importance of marginal analysis business is a good game...you...

7Output, Price, and Profit:

The Importance of Marginal Analysis

Business is a good game . . .You keep score with money.

NOLAN BUSHNELL, FOUNDER OF ATARI

● 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

● 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

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● Conclusion: The Fundamental Role of Marginal Analysis

● The Theory and Reality: A Word of Caution

● Appendix: The Relationships Among Total, Average, and Marginal Data

● Conclusion: The Fundamental Role of Marginal Analysis

● The Theory and Reality: A Word of Caution

● Appendix: The Relationships Among Total, Average, and Marginal Data

Contents (continued)Contents (continued)


Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

Price and Quantity: One Decision, Not TwoPrice 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.

● Firms face a demand curve on which price and quantity are related.

● They can choose either price or quantity, but not both.

FIGURE 7-1 Demand Curve for Al’s Garages

FIGURE 7-1 Demand Curve for Al’s Garages


15

25

16

D

D

Profit maximum

5

5

Output, Garages Marketed per Year

Pri

ce p

er G

arag

e (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

10

20 19

22

26

30

35

i h

g

e f

d c

b a

j


Total Profit: Keep Your Eye on the GoalTotal 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

● Simplifying assumption: maximum total profit is the firm’s goal.

● Total profit = total revenue - total costs

● Economic profit accounting profit



● 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.

● 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.

TABLE 7-1 Demand for Al’s Garages

TABLE 7-1 Demand for Al’s Garages


FIGURE 7-2 Total Revenue Curve for Al’s Garages

FIGURE 7-2 Total Revenue Curve for Al’s Garages


TR

A

B

C

D E

F G H I

J

5

To

tal R

even

ue

per

Yea

r (t

ho

usa

nd

s $)

Output, Garages Sold per Year

10 9 8 7 6 4 3 2 1 0

20

40

60

80

100

120

140



● 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.

● 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.

TABLE 7-2 Al’s Total, Average, and Marginal Costs

TABLE 7-2 Al’s Total, Average, and Marginal Costs


FIGURE 7-3 (a) Cost Curves for Al’s Garages

FIGURE 7-3 (a) Cost Curves for Al’s Garages


TC

(a) Total Cost Output, Garages per Year

5

To

tal

Co

st p

er Y

ear

(th

ou

san

ds

$)

10 9 8 7 6 4 3 2 1 0

20

40

60

200

180

160

140

120

100

80

FIGURE 7-3 (b) Cost Curves for Al’s Garages

FIGURE 7-3 (b) Cost Curves for Al’s Garages


(b) Average Cost Output, Garages per Year

5

Ave

rag

e C

os

t p

er G

arag

e (

tho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

5

10

15

45

40

35

30

25

20 AC

FIGURE 7-3 (c) Cost Curves for Al’s Garages

FIGURE 7-3 (c) Cost Curves for Al’s Garages


MC

(c) Marginal Cost Output, Garages per Year

5

Mar

gin

al

Co

st p

er A

dd

ed G

arag

e (t

ho

usa

nd

s $

)

10 9 8 7 6 4 3 2 1 0

5

10

15

45

50

40

35

30

25

20



● Maximization of Total Profits♦ Profits typically increase with output, then fall.

♦ Some intermediate level of output, therefore, generates the maximum profit.

● Maximization of Total Profits♦ Profits typically increase with output, then fall.

♦ Some intermediate level of output, therefore, generates the maximum profit.

TABLE 7-3 TR, Costs, and Profit for Al’s Garages

TABLE 7-3 TR, Costs, and Profit for Al’s Garages



Marginal Analysis and Maximization of Total ProfitMarginal 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.

● Marginal profit is the slope of the total profit curve.

● Profit is at a maximum when the marginal profit is zero.

FIGURE 7-4 (a) Profit Maximization

FIGURE 7-4 (a) Profit Maximization


TC

TR

22,000

Profit

(a) Total Revenue. Total Cost Output, Garages per Year

5 To

tal R

even

ue,

To

tal C

ost

per

Yea

r (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

200

180

160

140

120

100

80

60

40

20

74 B

96 A

FIGURE 7-4 (b) Profit Maximization

FIGURE 7-4 (b) Profit Maximization


5

(b) Total Profit Output, Garages per Year

Total profit

F

D

E C

10 9 8 7 6 4 3 2 1

–80

–60

–40

–20

0

20

40

To

tal

Pro

fit

pe

r Y

ea

r (t

ho

us

an

ds

$)

M 34



● Optimum Marginal Revenue and Marginal Cost♦ If MR > MC, production profits

♦ If MR < MC, production profits

● Profit maximizing level out output: MR = MC

● Optimum Marginal Revenue and Marginal Cost♦ If MR > MC, production profits

♦ If MR < MC, production profits

● Profit maximizing level out output: MR = MC

TABLE 7-4 Al’s Marginal Revenue and Marginal Cost

TABLE 7-4 Al’s Marginal Revenue and Marginal Cost


FIGURE 7-5(a) Profit Maxim: Another Graphical Interpretation

FIGURE 7-5(a) Profit Maxim: Another Graphical Interpretation


Output, Garages per Year (a) Marginal Revenue and Marginal Cost

5

MR

an

d M

C p

er

Gar

age

pe

r Y

ear

(th

ou

san

ds

$)

10 9 8 7 6 4 3 2 1

–10

0

10

20

30

40

50

MR

MC

E

FIGURE 7-5(b) Profit Maxim: Another Graphical Interpretation

FIGURE 7-5(b) Profit Maxim: Another Graphical Interpretation


TC

TR

22,000

Profit

(a) Total Revenue. Total Cost Output, Garages per Year

5 To

tal R

even

ue,

To

tal C

ost

per

Yea

r (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

200

180

160

140

120

100

80

60

40

20

74 B

96 A

FIGURE 7-5(c) Profit Maxim: Another Graphical Interpretation

FIGURE 7-5(c) Profit Maxim: Another Graphical Interpretation


5

(b) Total Profit Output, Garages per Year

Total profit

F

D

E C

10 9 8 7 6 4 3 2 1

–80

–60

–40

–20

0

20

40

To

tal

Pro

fit

pe

r Y

ea

r (t

ho

us

an

ds

$)

M 34



● 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.

● 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.


Logic of Marginal Analysis & MaximizationLogic 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.

● 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.


Logic of Marginal Analysis & MaximizationLogic 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.

● 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.

TABLE 7-5 Rise in Fixed Cost: Total Profits Before and After

TABLE 7-5 Rise in Fixed Cost: Total Profits Before and After


FIGURE 7-6 Fixed Cost Does Not Affect Profit-Maximizing Output

FIGURE 7-6 Fixed Cost Does Not Affect Profit-Maximizing Output


5 10 9 8 7 6 4 3 2 1

Profit with a fixed cost

Profit with zero fixed cost

N

To

tal

Pro

fit

per

Yea

r

(th

ou

san

ds

$)

Output in Garages per Year

M

0

40

20


The Fundamental Role of Marginal AnalysisThe 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.

● 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.


The Fundamental Role of Marginal AnalysisThe 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.

● 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.


Theory and Reality: A Word of CautionTheory 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.

● 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.

Appendix: Relationships Among Total, Average, and

Marginal Data


● Average = total the number of units

● Total = average the number of units

● Average = total the number of units

● Total = average the number of units

Relationships Among Total, Average, and Marginal DataRelationships Among Total, Average, and Marginal Data


Relationships Among Total, Average, and Marginal DataRelationships 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.

● 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.

TABLE 7-6 Weights of Persons in a Room (in pounds)

TABLE 7-6 Weights of Persons in a Room (in pounds)



● 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.

● 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.

Relationships Among Total, Average and Marginal DataRelationships Among Total, Average and Marginal Data

FIGURE 7-7 Relationship between Marginal and Average Curves

FIGURE 7-7 Relationship between Marginal and Average Curves


F

E

A D

B

C

Average weight

Marginal weight

Mar

gin

al a

nd

Ave

rag

e W

eig

ht

(po

un

ds)

Number of Persons

6 5 4 3 2 1 0

50

100

150

7 7 output, price, and profit: the importance of marginal analysis business is a good game...you...

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