Marginal revenue, marginal cost, and profit maximization in economics

Accounting Economics

Marginal Analysis

Define marginal revenue.

Explain its relationship with total revenue.

Marginal Revenue (MR) is the revenue that is linked to one more additional unit of production. The demand for the product will determine whether it will be higher or lower or even the same as the previous unit of production revenue. MR can be defined therefore as the addition realized revenue to the Total Revenue (TR) by a unit increment in the sales volume of a firm in the market (Economics Concepts, 2011).

For instance if a lime factory sells 100 liters of lime at $4 per liter, the total revenue of the factory would be $400. Incase the factory increases the sales volume from 100 liters to 101 liters, then the total revenue of the factory increases to $404. The increase by $4 in the total revenue by one unit increase in rate of sales per period of time is the MR.

Formula; MR = ?TR

Q

Where

MR is Marginal Revenue

TR is Total Revenue

Q is quantity

B. Define marginal cost.

1. Explain its relationship with total cost.

Marginal cost is the cost that a manufacturer incurs in producing one extra unit of an item. It is the cost of the additional inputs that are required to produce the output. It can also be referred to as the derivative of total production costs with respect to the output levels (Econ Model, 2011). As the production increases, the average total cost curve will decline as the fixed costs will be spread across the large number of goods being produced. This will however change according to the law of diminishing returns and the curve of the average total cost will start climbing.

The total cost can be found by combining variable cost and fixed cost combined

TC = VC+FC

When the total cost is divided by the quantity of goods produced then we get the average total cost.

ATC = TC/Q

Therefore the marginal cost will be the result of the change in total cost divided by the change in quantity

MC=?TC

Q

The total cost and the marginal costs are related in that if the total cost curve has a positive slope (upward sloping), then the marginal cost is also positive. More so, if the total cost curve has a positive slope that becomes increasingly steeper, then the marginal cost is positive and rising.

C. Define profit.

1. Explain the concept of profit maximization.

Profit can be defined as the sum total of the amount remaining after the costs whether they are direct or indirect costs, have been deducted from the income of a particular business venture. It can be in a summery said to be the excess of selling good's price over their cost (Merriam Webster, 2011).

Profit maximization can be found by equating marginal revenue with the marginal costs. Regardless of the market structure, the fact that marginal revenue equals marginal cost is normally used to indicate the profit maximizing levels of output of businesses (John Wiley, 2011). This process that businesses undergo to determine the bets price levels and best output is what is referred to as price maximization. The firms will more often than not adjust influential factors like sale prices, production costs and output levels in a bid to maximize the profits as projected. Most companies use either Marginal Cost-Marginal revenue method or Total cost-Total revenue methods to achieve their profit maximization. Profit maximization can be a good thing for the business or company but can turn out to be a bad idea to the customers when the company starts to use substandard items for the sake of profit maximization, or even decides to raise prices altogether.

D. Explain how a profit-maximizing firm determines its optimal level of output, using marginal revenue and marginal cost as criteria.

The optimal level of output is realized by a firm when they achieve the highest possible profit levels in that firm. The marginal revenue vs. The marginal cost is one of the prominent ways to determine the levels of profit maximization. The maximum profits can be said to have been realized when the marginal cost is equal to the marginal revenue. This is where the two intersect in the graph and optimal levels of production are assumed to have been obtained. At this level any increase in the production of the goods will lead to additional costs than revenue hence reduce the profits and on the other hand, any decrease in production will subtract more from the revenue of the firm than reduce the cost leading to a consequent decline in profits (Amos Web, 2011).

The profit maximization can also be determined by using the Marginal Cost Marginal Revenue method. In this method, for each unit that has been sold, the marginal profit is found by taking the marginal revenue minus the marginal cost. In this case if the marginal revenue is higher than the marginal cost then the marginal profit is said to be positive. On the other hand if the marginal revenue is found to be less than the marginal cost then it is noted that the marginal profit is negative. The marginal profit can as well be zero, in a situation where the marginal cost is same as the marginal revenue. It is apparent therefore that the total profit will increase when the marginal profit is positive and in the same manner decrease when the marginal profit is negative, therefore total profit must be maximum in a situation where the marginal profit is at zero (Anastacia Zoldak, 2011). In order to achieve this profit maximization strategy, the firm must increase their sales as well as minimize their costs.

E. Explain what action a profit-maximizing firm takes if marginal revenue is greater than marginal cost.

In a situation where the MR is greater than the MC, then a profit maximizing firm should increase the levels of production since the ideal production levels or output levels are determined by letting the marginal cost to be equal to the marginal revenue, it is only when this equality is achieved that the firm can boast of having achieved the profit-maximization limits.

F. Explain what action a profit-maximizing firm takes if marginal revenue is less than marginal cost.

When the MR is less than the MC, then a profit-maximizing firm needs to reduce the outputs and the reduction of production will lead to lesser costs for the firm. This should continue until the MR and the MC are equal so as to achieve the optimum output levels and maximum profits.

Task Two

Supply and Demand

A. Define the following three terms:

1. Elasticity of demand

2. Cross-price elasticity (include substitutes and complements)

3. Income elasticity (include normal and inferior goods)

Elasticity of demand

This indicates how much quantity demanded changes when the prices of goods or services change. It measures the responsiveness of the quantity of demand to the price changes in the market (Samuel L.B., 2006). The change in price may at times cause significant changes in demand, for instance many people would seek for alternative holiday spots locally with the increased airfares, while the increase in the price of coffee may not affect much the demand among those who see it as an essential commodity. It is therefore said that the more the quantity changes due to prices the more elastic the demand is. The elasticity of demand is very significant for any organization since it helps to foretell the effects of change in price to the revenue of the firm (Business Book Mall, 2011).

For instance if

Old Price =9

New Price =10

Quantity Demand (OLD) =150

Quantity Demand (NEW) =110

To calculate the price elasticity, we need to know the % change in quantity demand and then the % change in price.

%?QD=QD (New)-QD (Old)

QD (Old)

With our numerical above we get:

%?QD =[110-150] / 150 = (-40/150) = -0.2667

Hence the %?QD = -0.2667 (this can be left in decimal terms, however in percentage terms this would be -26.67%).

%?P=P (NEW) - P (OLD)] / P (OLD)

With our numerical above;

%?P =[10-9] / 9 = (1/9) = 0.1111

From the above two values found we can calculate the price elasticity of demand.

PEoD = %?QD

%?P

PEoD = (-0.2667)/(0.1111) = -2.4005

When analyzing price elasticity the concern is on their absolute value, so the negative value is ignored. Hence the price elasticity of demand, when the price increases from $9 to $10 is 2.4005 in our example above. The following should be noted of the price elasticity of demand values that may be found:

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes)

If PEoD = 1 then Demand is Unit Elastic

If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

Cross-price elasticity (include substitutes and complements)

This is the percentage change in the quantity demand of one product occasioned by a given percentage change in the price of a related product. With the variation in the prices, the demand of a particular item does not solely rely on its price but that of other products as well that may be a substitute or a complement to it. Cross-price elasticity is used to classify and group items that may compete against each other. For instance if the increase in the price of item X results in the increase of demand for item Y with the price of Y remaining constant, then the items or products X and Y are said to be substitutes.

On the other hand if the price of item A results into the drop in the quantity demand for B, yet the price of B. remains constant, then it can be said that items A and B. are complements (EOCD, 2002).

The cross price elasticity coefficient is calculated by the formula

Cross price Elasticity of Demand

= % ? QoA

% ? PoB

Where: QoA is the quantity of demand for good A

PoB is the price of good B

For instance if the price of a Toyota car increases by 8%, and in the same window of time the demand for Nissan car of the same model climbs by 2% the cross price elasticity of demand for Nissan car would be 0.25. These two items are said to be substitutes as the cross price elasticity is greater than zero.

Another example is if the price of pizza increase by 10%, making the demand for soft drinks to dip by 20% then the cross price elasticity would be -0.2 hence the goods here are said to be complementary goods.

Income elasticity (include normal and inferior goods)

Income elasticity of demand refers to the proportionate change in demand for an item in response to the income levels change. This is seen in the way people change their spending habits due to the change in the level of income that they undergo. In economies that are growing, the goods that are income-dependent do sell more than those that are not income-dependent (Business Dictionary, 2011). This income levels and spending levels will enable firms to know which the inferior goods are and which the normal goods are. The normal goods are those whose demand increases with the increase in the income levels, while the inferior goods are those whose demand drops with the increase in income levels for instance the Tesco value cakes and bread may be demanded less ad the income levels rise.

The income elasticity coefficient is calculated by the formula

Income Elasticity of Demand

=% ?QD

% ?I

Where: QD is quantity demanded

Availability of substitutes

The availability of substitutes will affect the demand elasticity of any commodity. For instance if there are substitute grapes in a grocery, the increase in price of grapes from one farm will lead to an increase elasticity of the demand for that particular grape since consumers will go for grapes from alternative farm.

Share of consumer income devoted to a good

The amount or share of consumer income devoted to a good can significantly affect the demand elasticity of that item. For instance if an individual spends 5% of him income on coffee each month and the price increases slightly such that he as has to spend 5.5% of the income on coffee that may not drive him into looking for other alternatives hence make the demand inelastic. But if the same coffee can have a price increase that will make the customer spend 30% of his income on coffee up from 5%, then he will definitely opt for alternatives hence making the demand more elastic.

Consumer's time horizon

Consumer's time horizon can also affect the elasticity of the demand in that if a client can do without an item at a particular time and wait for the offer seasons like Christmas offers then at the time he is not buying the goods it can be said that his demand is elastic.

E. Provide an example for each of the three determinants in part D.

1. Explain the logical impacts to business decision making that result from each of the examples you provided in part E.

On the availability of the grapes in a grocery from other farm, there is need for the management to study the prices of other farms that supply that grocery with grapes and decide strategically on whether to increase their prices or not. In case the farm decides to increase the prices, then they should include an accompanying reason that would make the customers still buy their grapes, like packaging that is slightly better than the other farms yet not compromising the profit margin due to significant increase in production costs. If this is not adhered to the impact would be a loss of the market share that they had to a competitor.

Taking the case of the 5% spending on coffee per month, the businesses must look into the percentage that their clients spend in their products and when increasing the prices, they should do so in a manner that will not upset the budget of the customers and hence ending up losing them to the competitor, the increase can be gradual over years so that clients can adjust with time to the new prices.

F. Differentiate between perfectly inelastic demand and perfectly elastic demand.

1. Illustrate the difference between the terms in part F with specific descriptions or graphs

A perfectly inelastic demand happens when the levels of the demand for the goods is totally not affected by the change in the price. The quantity demanded is totally unresponsive to the price changes

Ed=0

Note that the 5% increment in price does not affect the demand

A perfectly elastic demand can be said to be a situation where at a given price, the demand is infinite. This happens mostly in highly competitive markets where a slight increment in price can lead to customers buying from other known competitors.

Here the demand curve is perfectly horizontal change in price would mean a decline in demand.

G. Explain the relationship between elasticity of demand and total revenue for the following ranges along the demand curve, using the attached "Graphs for Elasticity of Demand, Total Revenue." Include the impacts to quantity demanded and total revenue when there is a price decrease, ceteris paribus.

1. Elastic range

2. Inelastic range

3. Unit-elastic range

Elastic range

In the elastic range, an increase in the price of a commodity will result into a decrease in demand for the goods. This will consequently affect the revenue of the firm since the production costs will still be held at the same level as the quantities produced whether there is demand for them or not. Indeed as the quantities manufactured increase and the attached graph 1 indicates, there will continually be dropping revenue unless there is demand for it. In case there is price decrease, then there is likelihood of experiencing a rise in demand, though this may not necessarily mean a significant increase in revenue since this will depend on how low the price has been dropped. It is worth noting however that incase it is a perfectly elastic demand situation in a competitive market, a slight drop in the prices that may not hurt the firm can significantly attract more customers and consequently increase revenue significantly. As the attached graph 2 indicates, there is an increase in demand with the price reduction, at the unit price of $40 the elasticity is at unit elastic, beyond that is the elastic zone (between $80 and selling 1 unit to $50 and selling 4 units hence giving revenue between $80 and $200) where there will be significant change in demand with the price change.

Inelastic range

In an inelastic demand situation, there will be no change or little change that can be experienced with the decrease in the prices; this is below $40 (between $40 and $0, from 5 to 9 units demanded quantity and a revenue of between $200 to $0), giving us the inelastic zone where the change in price does not change much the demand that is experienced by the firm.

It is worth noting that even in the event that the prices are reduced, there will not be any significant increase in the demand and revenue since the customers in this range are not price sensitive.

Unit-elastic range

This is an interesting situation in the elasticity of demand since it holds the demand elasticity coefficient at 1. This means that a percent change in prices results into a percent change in quantity by the same proportion. This therefore means that the demanded quantity against price graph will be at 45 degrees and remain so with every increment in price. It is assumed that this proportionality should remain the same even upon reduction of the prices but practically this proportion is likely to the altered with the decrease in prices hence shifting the range more towards the elastic range. On the graphs, the unit elastic range is found between the points the unit price is $50 and the sold units are 4 downwards to where the unit price is $40 and the sold units are 5 units and the revenue stands at $200 in both cases.

Task three

Competition

A. Define industrial (i.e., economic) regulation.

1. Explain why industrial regulation exists.

2. Explain how industrial regulation affects the market.

3. Explain the entities affected by industrial regulation in terms of market structure.

a. Explain why industrial regulation affects those entities you identified.

Industrial regulation or economic regulation has a wide range of definitions and there has hardly been any consensus on a single definition of the word. However, there are some definitions that tend to recur that define economic regulation as the government control of outputs, their prices as well as the market entry. Before the 1970s this definition covered controls over the significant industries like the transport, telecommunication, energy and the agricultural sector. However, from 1970s onwards, there has been less and less government interference especially in the industrial sector and instead deregulation has been the order of the day (Daniel A. Farber, 2000).

In a broader sense, economic regulation can be seen as regulation of activities that relate to the market transactions by the government. These transactions can be both actual and the potential or foreseeable transactions.

1. Explain why industrial regulation exists.

A trade environment that is guided and regulated by a healthy set of regulations is vital to the progress and success of business in any region. Some of the reasons why industrial exist and must continue