Question

A profit-maximizing firm will increase production when (LO3) a) price is less than marginal cost b) price equals marginal cost c) price exceeds marginal revenue d) price exceeds marginal cost

Short answer

A profit-maximizing firm will increase production when the price exceeds marginal cost (Option d).

Step-by-step solution

Option a) Price is less than marginal cost

In this case, the firm is losing money on every additional unit produced since the cost of producing each unit is greater than the price the firm can sell it for. Therefore, a profit-maximizing firm will not increase production under this condition.

Option b) Price equals marginal cost

When the price equals the marginal cost, the firm breaks even on each additional unit produced. Although the firm is not losing money, it is also not maximizing its profit as it is not making any profit on the additional units. So, a profit-maximizing firm will not increase its production when price equals marginal cost.

Option c) Price exceeds marginal revenue

This scenario compares price with marginal revenue. It doesn't discuss the relation between marginal cost and price or marginal revenue. When price exceeds marginal revenue, it is not a sufficient condition to determine whether the firm will increase production as we need to consider the relationship between price (or marginal revenue) and marginal cost for decision making. Hence, we cannot say whether a profit-maximizing firm will increase production.

Option d) Price exceeds marginal cost

In this case, the price the firm can sell its products for is greater than the cost of producing each additional unit. This means that the firm makes a profit on each additional unit produced. So, a profit-maximizing firm is incentivized to increase production under this condition, as they can make more profit by producing more units. The correct choice is: d) A profit-maximizing firm will increase production when the price exceeds marginal cost.

Key concepts

Marginal Cost

Marginal cost is an essential concept in economics that measures the cost of producing one additional unit of a good or service. It helps businesses understand the expense associated with increasing output by a single unit. When making production decisions, firms always consider the marginal cost because it indicates whether producing an extra unit will be profitable. If the marginal cost is less than the selling price, the firm stands to make a profit. If it's more, the firm incurs a loss on that additional unit.

Marginal cost is calculated using the formula: \[ MC = \frac{\Delta TC}{\Delta Q} \]where \(\Delta TC\) is the change in total cost and \(\Delta Q\) is the change in quantity produced. By regularly analyzing marginal costs, firms can make informed decisions on whether to increase or decrease their production levels.

Marginal Revenue

Marginal revenue is the additional revenue that a firm gains when it sells one more unit of its product. It plays a significant role in determining the level of production a firm should aim for to maximize profits.

The relationship between marginal revenue and marginal cost is crucial. If marginal revenue is greater than marginal cost, selling additional units increases overall profit. Conversely, if marginal revenue is less than marginal cost, the firm loses money on the additional units. This is particularly important for firms operating in competitive markets where pricing strategies need to align with profitability goals.

The formula for marginal revenue is: \[MR = \frac{\Delta TR}{\Delta Q}\]where \(\Delta TR\) is the change in total revenue and \(\Delta Q\) is the change in quantity sold. Firms aim to continue producing and selling additional units as long as marginal revenue continues to exceed marginal cost.

Production Decision

A firm's production decision revolves around determining the optimal quantity of output that maximizes its profits. The decision-making process involves assessing both marginal cost and marginal revenue. For profit maximization, these two should balance in the best way possible.

If the price a firm can sell a product for (which equates to marginal revenue in perfect competition) is greater than the marginal cost, increasing production is beneficial. Here, each additional unit contributes positively to the firm's profit. On the contrary, if the marginal cost exceeds what the firm earns from selling that extra unit, reducing production is advisable to prevent losses.

In essence, the optimal production level is achieved where marginal cost equals marginal revenue. At this point, producing more or fewer units would either reduce profits or increase losses.

Economic Profit

Economic profit represents the difference between total revenue and total costs, including both explicit and implicit costs. It's a more comprehensive measure of profitability than accounting profit because it considers opportunity costs—what a firm forgoes by choosing a particular course of action.

Firms strive for economic profit as it signifies true financial success and efficient resource allocation. When a firm achieves economic profit, it means it's not just covering all its costs but also earning more than it could have by investing its resources elsewhere.

Decision-making centered around economic profit ensures that firms focus on sustainability and long-term success by making the most effective use of their resources. Firms aim to reach a state where their economic profit is positive, indicating fruitful returns from production and sales activities.