Marginal Revenue and Marginal Cost - Essay Example

This relationship between marginal cost and the total cost can be expressed asMarginal Cost = ∆ Total Cost / ∆ OutputProfit is defined as the difference between the Total Revenue and Total Cost.

Since total revenue and total cost are functions of total output; profit is also a function of total output (Pearson Education, 2005).Profit maximization is a procedure by which a firm determines the level of price and output at which maximum profit is achieved. According to profit maximization theory, a firm can calculate marginal profit for each unit by subtracting marginal cost from marginal revenue. The total profit increases when marginal profit is positive i.e. when marginal revenue is greater than marginal cost.

Similarly, the total profit decreases when marginal profit is negative i.e. marginal revenue is less as compared to marginal cost. Maximum total profit is achieved when marginal profit becomes zero. At this point, marginal revenue is equal to marginal cost. A further increase in output leads to a negative marginal profit or a marginal loss i.e. the total profit starts decreasing. Thus, maximum profit is achieved at a point where marginal profit is equal to marginal revenue. Figure 1 shows the graphs for Total Revenue, Total Cost, Marginal Revenue, Marginal Cost, and Total Profit.

The profit is maximized at output = q*.Figure 1: Revenue and Cost CurvesIf the marginal revenue of a firm exceeds the marginal cost, a firm is in a healthy position. Its marginal profit is positive. The firm would hence need to take steps to increase the level of output with the current resources provided the demand for the same exists. Additional labor may be required increasing cost but additional capital expenditure is generally not made in the short run. The firm may also take action to boost market demand.

These may include marketing and promotional activities.If the marginal revenue of a firm is less than the marginal cost, the firm is operating at sub-optimal levels. The firm needs to analyze whether the output produced is actually required. If not, the output levels are decreased. However, if the demand exceeds the output, the firm needs to take other steps such as setting up new production plants, laying off certain laborers, and so on. Most of these steps are taken in the long run. In extreme cases, firms may even decide to create situations so that the net market demand is lowered.