Marginal Cost and Marginal Revenue

¶ … marginal cost and marginal revenue to yield maximum profits for businesses. It intends to show the relationship between the comparison of cost and revenue and maximized profit. At the end of the paper the reader will get a fair idea about the theory as well as application of the theory in firms and business in the real world. It is the aim of every businessman to increase his profits to such an extent where he is acquiring maximum profits.

In the field of economics, profit maximization is a process adopted by a firm to determine the price and the output level of the produce which would generate the greatest profit. There are many approaches to this of which one of them is the comparison of marginal revenue and marginal cost. Cost and revenue comparison to maximize profit is used to calculate whether an additional unit of product or service being sold would generate increased profits or would it be a bad idea altogether.

It is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost. COMPARING COST AND REVENUE TO ACHIEVE MAXIMUM PROFITS Business institutions calculate their total cost and revenues to adjust their production in a way to maximize profits. A higher production need not always mean greater profit and thus by this study businessmen seek to find such an output level that would yield them maximum profits.

Firms and businesses expand output to the point where their marginal revenue equals the marginal cost as the point where marginal cost surpasses the marginal revenue then the profits decline. The quantity which would give maximum profits can be calculated by comparing the marginal revenue and the marginal cost and producing so much that marginal revenue equals marginal cost.

'Since Cournot's [1838] classic analysis of a hard-nosed sole proprietor of a spring pricing water to maximize his profit, the simple theory of monopoly has concluded that a monopolist will produce the level of output at which marginal revenue is equal to marginal cost, and sell this output at the market clearing price, (Hicks [1935])." [Steven P. Cassou and John C. Hause] To understand this method theoretically we can take a hypothetical example of a firm and analyze its profits with the production of an additional unit of output.

When an additional unit of output is produced by a firm, its revenue increases and so does its cost. If the revenue increase is more than the cost increase then the firm is said to have made a profit. If the cost rises more than the increase in revenue then the firm has experienced a fall in profits.

The additional revenue generated by the production of an additional unit is called "Marginal Revenue." Similarly the additional cost that is tied to the production of that additional unit is called "Marginal Cost." For each unit sold, marginal profit equals marginal revenue minus marginal cost. Therefore if the marginal revenue increases more than the marginal cost then it is obvious that there has been an increase in the revenue of the firm rather than the costs.

On the other hand if the production of an additional unit causes the marginal cost to increase more than the marginal revenue, it means that the production of this unit costs more than the revenue which it will generate on its sale. In such a scenario the firm needs to abort the idea of producing this additional unit and thus should decrease it production to the previous quantity.

In 1960s when most airlines made decisions regarding profits based on the percentage of seats filled on a flight, Continental Airlines made decisions regarding which flights to fly based on the principle of marginal cost and marginal revenue. They compared the extra costs of a flight with the revenues that it would generate and then make a decision. [Profit in Real Firms] Today airlines use the Fleet Assignment Model which assigns aircraft types to an airline timetable in order to generate maximum profits.

This is similar to what Continental Airlines practiced and is based on the principles of maximizing profits by calculating marginal revenue and marginal cost. The Fleet Assignment Models have increased profit margins which are constraint to factors such as that each flight in the schedule has to be assigned a particular type of aircraft. The assignment is such that the number of aircrafts cannot exceed the number available in the fleet.

Profit Maximization through the comparison of cost and revenue is now being widely practiced due to its effectiveness in fulfilling the desired goal. Firms and businesses tend to keep records of the cost and revenues in order to study the comparison of the two. The Inland Press Association has been keeping data regarding cost and revenue since 1919 so that participants can compare their performance with the financial performance of other competitors. [William B. Blankenburg] A cable provider also uses the same method to determine maximum profits.

He keeps on adding channels until his marginal revenue equals the marginal cost. The operator might choose to leave a channel unused and only program that many channels which are economically feasible. Increased maintenance, operative and administrative costs along with the payment for the networks would be the factors that add up to the marginal cost of adding a new channel. With these increased costs, the clientage of the cable provider adds to the marginal revenue.

However another factor that will add up to the revenue would be the local advertisement. As advertisement would also add to the revenues generated by a cable operator, therefore it may become a positive factor in increasing the marginal revenue of adding a channel. "Dertouzos and Wildman (1993) emphasized that the cost of running a cable system constituted critical differences between markets, and that factors that accounted for the systematic difference between systems should be accommodated when studying cable.

Among other factors include costs and revenues of the system influence local cable operation including programming decisions." [Eun-Mee Kim p.24] A profit.