Question

A student argues: "To maximize profit, a firm should produce the quantity where the difference between marginal revenue and marginal cost is the greatest. If a firm produces more than this quantity, then the profit made on each additional unit will be falling." Briefly explain whether you agree with this reasoning.

Short answer

The argument is partly correct. While it's true that producing beyond the point where marginal cost equals marginal revenue results in falling profit per unit, it's incorrect to assert that profit is maximized by producing at the point where the difference between these two variables is greatest. Profit maximization occurs at the output level where marginal revenue equals marginal cost.

Step-by-step solution

Understanding Terms

Before evaluating the statement, it is essential to comprehend the terms used. Marginal Revenue (MR) is the revenue gained from selling one additional unit of a product, while Marginal Cost (MC) is the cost incurred by producing one additional unit of the product. Profit is maximized at the point where MR = MC.

Evaluating the Statement

Now that the terms have been clarified, it is possible to assess the claim. The assertion that to maximize profit, a firm should produce at a level where the difference between MR and MC is greatest, is incorrect. Economically, profit maximization occurs at the output level where MR equals MC. This is because at the point where MR equals MC, the cost of producing an additional unit is precisely compensated by the revenue received from selling it, so this is the last unit at which profit increases.

Analyzing Greater Production

The next part of the argument posited that producing beyond this point results in falling profit per unit. This is correct. When a firm produces beyond the point where MR equals MC, the MC is larger than the MR. This means that the cost to produce each additional unit is greater than the revenue it generates, resulting in a decrease in total profit.

Key concepts

Marginal Revenue

Marginal Revenue (MR) is a fundamental concept in economics that represents the additional income a firm receives when it sells one more unit of a product or service. Imagine a lemonade stand that sells a cup for $1; if selling an extra cup brings in another dollar, that dollar is the marginal revenue. Mathematically, if total revenue increases from \( TR \) to \( TR + \Delta TR \) after selling one additional unit, the marginal revenue \( MR \) is \( \Delta TR \) (the change in revenue).

It is a crucial figure for decision-making in business. Firms use MR to determine the optimal quantity to produce and sell. The goal is to continue producing until the MR of the last unit is equal to its Marginal Cost (MC), which means no additional profit can be generated by producing more. Producing less would mean forsaking potential profits, while producing more would eventually bring down overall profitability, which is explained in the statement given by the student in the exercise.

Marginal Cost

Understanding Marginal Cost

The Marginal Cost, on the other hand, refers to the cost of producing one additional unit of a good or service. It includes all the variable costs that vary with production levels, such as raw materials, labor, and energy. As production ramps up, marginal costs can change due to factors like economies of scale or increased overtime pay for workers.

A simple equation to represent marginal cost is the change in total cost (\( \Delta TC \) ) divided by the change in quantity (\( \Delta Q \) ), so \( MC = \Delta TC / \Delta Q \). Companies aim to produce up to the point where \( MR = MC \) because beyond this point, the cost of making an additional unit exceeds the revenue it generates, which would lead to a decrease in profit for each extra unit sold.

Economic Profit

Profit vs. Economic Profit

Profit is what businesses aim to maximize — it's the financial gain which is the difference between total revenue and total costs. However, in economics, we focus on the concept of economic profit, which is more precise. It factors in opportunity costs, the profits a firm could have made if it had chosen the next-best alternative with its resources. In short, economic profit is total revenue minus total costs (both explicit and implicit).

When firms look at maximizing profits, they're not just looking at the monetary inflow but considering the entire cost structure including forgone opportunities. Hence, economic profit is a key measure that tells us whether a firm is doing better than if it had invested its resources elsewhere. For true profit maximization, the firm needs to generate economic profit, not just accounting profit.

Revenue Maximization

Revenue Maximization is a different goal from profit maximization, though they are often conflated. The objective of revenue maximization is to bring in the greatest amount of money from sales, without necessarily accounting for the costs associated with producing those sales. This might be a short-term strategy to increase market share or to leverage economies of scale.

However, it's crucial to understand that maximizing revenue doesn't always lead to maximizing profits, as it could entail selling more at a lower price point or incurring higher costs. Therefore, while a firm may increase its revenue, it could end up with a lower profit if the additional costs exceed the extra revenue. This aligns with the original exercise by pointing out the flaw in associating production level solely with revenue since costs play a significant role in determining profitability.