Marginal revenue and marginal cost are microeconomic concepts that are very significant in making production decisions. Marginal revenue refers to the revenue that is associable to the sale of the last unit of a product. The revenue for the aforementioned unit could either be the same as that of the previous unit, higher or lower. This depends on how the products of the producer are demanded in the market.
This means that it can take negative and positive values and thus it adds to total revenue, subtracts from it or keeps total revenue unchanged. Total revenue refers to the money that a firm receives from its sales. Marginal revenue is related to total revenue because it takes total revenue as its frame of reference. That is, to compute marginal revenue, the change in total revenue is taken and divided by the change in the number of sales. This is illustrated in the formula below
Marginal revenue = change in total revenue/ change in quantity
On the other hand, marginal cost refers to the cost of additional elements used in producing an additional unit. It can thus be viewed as the increment in total cost that occurs after the production of an additional unit of output.
Total cost refers to the fixed cost plus variable cost. Marginal cost is thus related to total cost since its value depends on fixed cost and variable cost just as the total cost depends on the two. Therefore, the calculation of marginal cost involves total cost and it is calculated as the change in total cost divided by the change in the number of units produced. That is,
Marginal cost = change in total cost/change in quantity
The two, marginal cost and marginal revenue, are specifically important because they are used in the determination of profit-maximizing output that is realized when the latter is equal to the former (Tohamy, 2009, p. 1).
Marginal cost and marginal revenue have a number of similarities and thus they are used together to help in decision making. For example, they are both useful in the determination of the suitability of a company for economies of scale. Thus an analysis of both marginal revenue and marginal cost is used to gauge the profitability of increasing its production. Additionally, they are both based on the production of a single additional unit.
That is, both the cost and revenue realized from the production of an additional unit are the definitions of marginal cost and marginal revenue respectively (McManus, 2007, p. 1). Again both marginal cost and marginal revenue are used in the computation of marginal profit and thus they are both helpful in strategic planning related to production.
Marginal revenue and marginal cost have a number of differences. These include the fact that high marginal cost implies that losses are incurred with increased production while high marginal revenue indicates the presence of economies of scale.
Profit refers to the amount of money that a business organization obtains from investing its resources in a given operation and after subtracting the expenses incurred during the operation (Graham, 2009, p. 1).
There are several types of profits. These include gross profit, the difference between sales and the cost of the sales, net profit- obtained after deduction of expenses and tax from gross profit, and operating profit which is obtained by the difference between gross profit and operating expenses. There are also other types of profits which include economic profit, optimum profit, etc.
The amount of profit that an enterprise makes depends on its ability to balance its use of resources in the generation of revenue. This implies that an enterprise strives to keep its cost of production and other costs as low as possible while generating the greatest possible amount of revenue. This necessitates a careful study of the profit that the enterprise makes with the expansion of its scope of the production (Tohamy, 2009, p. 1). This is enabled by the study of the third type of profit known as marginal profit.
Marginal profit can be defined as the profit made on an additional unit of produced. It is, therefore, the difference between marginal revenue and marginal cost. Since the marginal profit or marginal loss adds or reduces the aggregate profit respectively, it is in the interest of enterprises to conduct a careful study of these parameters in order to determine the level of output that maximizes its profit (Graham, 2009, p. 1).
Profit maximization refers to the process that involves making production decisions that enable an enterprise to make the greatest amount of profit possible. As discussed above, profit maximization depends so much on the level of output. That is why marginal cost and marginal revenue are important in profit maximization since they are used to determine which level of output has the best balance between marginal cost and marginal revenue.
Since the comparison of marginal revenue and marginal cost determines marginal profit, it also implies that marginal profit can be taken to be the key determinant of profit maximization. Consider the fact that an increase in marginal profit leads to an increase in the aggregate profit while marginal loss decreases the aggregate profit. This fact implies that the graph of the level of production versus marginal cost and marginal revenue has a peak at the point where marginal revenue is equal to marginal cost.
At this point, the total profit is at its highest and both an increase and decrease to the level of production will lead to a lower overall profit. The output at this point is known as the profit-maximizing level of output and it is the most productive level of output of the organization.
From the above discussion, the dynamics of both the marginal revenue and marginal cost should prompt action by the production managers of any enterprise. Profit is determined by the marginal profit that is obtained by deducting the marginal cost from marginal revenue (Tohamy, 2009, p. 1).
When marginal revenue is greater than the marginal cost, the resulting marginal profit is positive and thus the firm should increase its output since an increase in the level of production increases marginal profit which in turn increases the total profit. On the other hand, however, when the marginal cost of producing an extra unit in the enterprise is higher than the marginal revenue for the same, the marginal profit of the firm will be negative and thus it will reduce the total profit (Graham, 2009, p. 1).
This implies that such a scenario should prompt production managers to cut down production until it approaches or reaches the profit maximization point. The managers can also take other measures that are not related to production to maximize profit in the two aforementioned cases. In the case where the marginal revenue is greater than marginal cost, the managers can employ methods that cut the cost further.
On the other hand, when the marginal cost is higher than marginal revenue, the firm can look for methods of generating more revenue from additional products and thus increase the marginal revenue. The marginal cost and marginal revenue method of profit maximization are applicable in a variety of enterprises which include firms in perfectly competitive markets, firms in monopoly markets, etc.
The relationship between the level of production of a firm and the profit that the firm makes, in the long run, is indubitable. Even before the determination of the profit-maximizing level of output, a firm should involve itself in the production of a reasonable level of output depending on the amount and suitability of resources they have and the demand of their products in the market.
These are examples of the factors that determine if the marginal profit is negative or positive, and thus they determine the amount of profit that the organization makes (Graham, 2009, p. 1).
The goal of any business enterprise is to make the highest profit possible. It is thus the interest of any organization to maximize their profits. In this regard, enterprises should employ the available methods of profit maximization to ensure that the returns from their investments are impressive enough. Although the determination of the intersection of marginal revenue and marginal cost could prove to be challenging, enterprises should employ the marginal cost and marginal revenue approach to profit maximization.
This is particularly important for firms that engage in production since the approach enables them to determine the viability of economies of scale which enables them to expand their operations without fear. On the contrary, the approach is very useful to firms whose increase in production will decrease the total profits.
As mentioned earlier, this kind of analysis determines if the marginal profit is positive or negative. In this case, it is negative and thus the firm will be discouraged to dedicate their resources in increasing production. This will, in turn, help the enterprise avoid the wastage of raw materials and other resources on non-profitable production.
Reference List
Graham, H. (2009). Profit Maximization. Web.
McManus, S. (2007). Marginal Revenue. Web.
Mixon. J., Tohamy, S. (2009). Cost Curves and How They Relate. Web.