What is the difference between marginal cost and marginal revenue at the point when profits are maximized?

A rational business’s main goal is always to maximize profits. As complicated as business processes can be, the end goal always remains reaching the maximum profit. There are many ways a company has to examine the way it produces its products, but one of the most critical things to decide is how much a company wants to produce. Marginal costs and marginal revenue are important considerations in this decision-making process.

Table of Contents Show

Profit Maximization Formula
Why is the output chosen at MC = MR?
Application of Marginal Cost = Marginal Revenue
Profit Maximization Example
Limitations of the Profit Maximization Rule (MC = MR)
1. Real World Data
2. Competition
3. Demand Factors
4. Barriers to Entry
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Each company’s production is different. Some businesses produce actual tangible goods, where units are easy to measure. Other companies offer intangible goods like services or support, which can make it harder to evaluate “levels” of production. In order to find a profitable place to operate, the company needs to define its products as units, and then look at inputs and outputs.

The inputs to production are things like raw materials, utilities and the costs of operating whatever produces goods or services for the company. But the costs of production also include the overhead costs of the facilities involved, the sunk costs of the machinery, and the costs of the maintenance of the equipment.

Even in companies that work with human services, there are inputs such as salaries and time, but there are also overhead costs for buildings, utilities and other space. One of the clearest ways to evaluate this is to explore the marginal cost and marginal revenue for a certain product line, and compare them to each other.

Marginal cost is the added cost a company sees when producing one more unit. While it may seem like the cost to produce one extra unit is a constant, this isn’t actually the case. Overhead costs remain constant whether a company makes one unit or 100 units, so the cost to add one more unit is normally less than the cost to manufacture the first unit.

This is an example of the concept of economies of scale: When companies produce more units, the fixed costs are spread over those units. And while it obviously costs more in raw materials and production time to produce 1,000 units over 100, the average unit cost will be lower.

The marginal cost is then the cost to produce one more unit on top of normal production. For example, consider the company produces 1,000 units, and this costs the company $5,000; the cost to produce that 1,001st unit on top of the existing 1,000 is the marginal cost.

The cost to produce the first 1,000 units appears to be $5 per unit; the marginal cost to make that additional unit might be $3. Eventually, the cost to produce additional units will be reduced to the bare cost of the raw materials and the energy used to run the equipment.

Marginal revenue is the additional revenue a company will receive when selling one more unit, explains The Motley Fool. In a perfectly competitive market, the marginal revenue is equal to the price the company can charge the customer, because the concept of a perfectly competitive market is that customer demand is high enough that the company can sell all units for the same price, since unit price does not affect the market.

However, in imperfect markets, in order to sell one additional unit, the company needs to reduce the price of that unit. Because of this, marginal revenue will always decrease as production increases. So while it may appear that a company should make as many units as possible to minimize the marginal cost, at some point, the marginal revenue will become negligible.

These two concepts work in tandem to help a company set their levels of production. If marginal revenue is higher than marginal cost, then the company can continue to make more money by making more units. When marginal revenue is less than marginal cost, the company is actually losing money on units, and should cut back production. A company’s maximum profitability, then, can be reached when marginal costs equal marginal revenues.

This concept stands even when a business’ output is intangible. For example, a company’s units might in fact be employees offering services. In this case the company would compare the cost of adding an employee (including salary, desk, space, benefits and so on) with the revenue that employee would be expected to bring in by offering the company’s services.

As Khan Academy explains, the maximum point of profitability would then be when the marginal cost of bringing in a new employee equals the marginal revenue that employee will add to the bottom line. The concept of shared costs applies here as well; the overhead costs of the office space and the company’s normal operating costs can be spread out over the heads of more employees, just like the overhead costs of a production facility can be.

To determine the marginal cost and marginal revenue curve for your business, it’s helpful to have as many data points as possible. In addition, you may be able to use a marginal cost and marginal revenue calculator to help you. As The Intelligent Economist explains, this equation is MC = MR.

The key benefit of operating at this point is, of course, the maximization of profit. It allows the company to spread out the cost of production over a good number of units, while keeping the pricing to the point where each item will sell. Remember, the marginal revenue isn’t the actual revenue – it’s the measure of the increase in revenue from production of one more unit. Overall, this is the most profitable place for a company to operate.

The biggest disadvantage is, of course, that real markets don’t necessarily behave the way theoretical markets do. In practice, it’s difficult to find this point. It’s fairly easy to estimate costs, as they’re a known thing, and therefore reasonably straightforward to calculate a marginal cost that’s meaningful to the company. However, revenues can be more difficult to predict, especially in markets that are volatile.

Prices can change because of competitors, or because of growing monopolies, and this makes marginal revenue very challenging to estimate. Companies that make poor assumptions can end up with a number of units on their hands that won’t sell, or can end up missing out on a big market opportunity due to low production.

When the actual marginal revenue falls below the expected value, market analysis is important. It could be that the market has been saturated by competitors, or that the consumer’s attention is turning from one product to another.

At this point, the company needs to add value to the product to make up the difference in revenue; they can add features or bonuses to each unit, or work with research and development to generate new ideas for the product. At some point the calculation should be done again to find the new point where marginal cost meets actual marginal revenue, and production should be adjusted accordingly.

This type of analysis is called marginal analysis: an economic tool that breaks large numbers down into quantifiable, measurable units. It isn’t the only way to look at production levels, but it provides a way for management to look at the flows of their inputs and outputs and create some kind of balance. It helps narrow the conceptual problem down to one unit: that one additional unit over a certain standard level of production.

Even if the company makes 1,000 units a day, it’s only the added cost and revenue from the 1,001st unit that needs to be conceptualized. Using these kinds of comparisons, company leaders can help balance their production flows as markets change around them.

The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.

Profit Maximization Formula

The profit maximization rule formula is

MC = MR

Marginal Cost is the increase in cost by producing one more unit of the good.

Marginal Revenue is the change in total revenue as a result of changing the rate of sales by one unit. Marginal Revenue is also the slope of Total Revenue.

Profit = Total Revenue – Total Costs

Therefore, profit maximization occurs at the most significant gap or the biggest difference between the total revenue and the total cost.

Why is the output chosen at MC = MR?

At A, Marginal Cost < Marginal Revenue, then for each additional unit produced, revenue will be higher than the cost so that you will generate more.

At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be higher than revenue so that you will create less.

Thus, optimal quantity produced should be at MC = MR

Application of Marginal Cost = Marginal Revenue

The MC = MR rule is quite versatile so that firms can apply the rule to many other decisions.

For example, you can apply it to hours of operation. You decide to stay open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.

Or it can be applied to advertising. You should increase the number of times you run your TV commercial as long as the added revenue from running it one more time outweighs the added cost of running it one more time.

Profit Maximization Example

In the early 1960s 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.

In other words, they used the rule Marginal Revenue = Total Cost/quantity

Then Continental Airlines broke from the norm and started running flights even when the added revenues were below average cost. The other airlines thought Continental was crazy – but Continental made huge profits.

Eventually, the other carriers followed suit. The per-flight cost consists of variable costs, including jet fuel and pilot salaries, and those are very relevant to the decision about whether to run another flight.

However, the per-flight cost also includes expenditures like rental of terminal space, general and administrative costs, and so on. These costs do not change with an increase in the number of flights, and therefore are irrelevant to that decision.

Limitations of the Profit Maximization Rule (MC = MR)

1. 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. For example, it is difficult for firms to know the price elasticity of demand for their goods – which determines the MR.

2. Competition

The use of the profit maximization rule also depends on how other firms react. If you increase your price, and other firms may follow, demand may be inelastic. But, if you are the only firm to increase the price, demand will be elastic.

3. Demand Factors

It is difficult to isolate the effect of changing the price on demand. Demand may change due to many other factors apart from price.

4. Barriers to Entry

Increasing prices to maximize profits in the short run could encourage more firms to enter the market. Therefore firms may decide to make less than maximum profits and pursue a higher market share.