7 7 Output, Price, and Profit: The Importance of Marginal Analysis Business is a good game...You keep score with money. NOLAN BUSHNELL, FOUNDER OF ATARI Output, Price, and Profit: The Importance of Marginal Analysis Business is a good game...You keep score with money. NOLAN BUSHNELL, FOUNDER OF ATARI

●Price and Quantity: One Decision, Not Two ●Total Profit: Keep your Eye on the Goal ●Marginal Analysis and Maximization of Total Profit ●Generalization: The Logic of Marginal Analysis and Maximization ●Price and Quantity: One Decision, Not Two ●Total Profit: Keep your Eye on the Goal ●Marginal Analysis and Maximization of Total Profit ●Generalization: The Logic of Marginal Analysis and Maximization Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●Conclusion: The Fundamental Role of Marginal Analysis ●The Theory and Reality: A Word of Caution ●Appendix: The Relationships Among Total, Average, and Marginal Data ●Conclusion: The Fundamental Role of Marginal Analysis ●The Theory and Reality: A Word of Caution ●Appendix: The Relationships Among Total, Average, and Marginal Data Contents (continued) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Price and Quantity: One Decision, Not Two ●Firms face a demand curve on which price and quantity are related. ●They can choose either price or quantity, but not both. ●Firms face a demand curve on which price and quantity are related. ●They can choose either price or quantity, but not both.

FIGURE 7-1 Demand Curve for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved D D Profit maximum 5 5 Output, Garages Marketed per Year Price per Garage (thousands $) i h g e f d c b a j

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Total Profit: Keep Your Eye on the Goal ●Simplifying assumption: maximum total profit is the firm’s goal. ●Total profit = total revenue - total costs ●Economic profit  accounting profit ●Simplifying assumption: maximum total profit is the firm’s goal. ●Total profit = total revenue - total costs ●Economic profit  accounting profit

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Revenue ♦Total Revenue = P  Q ♦Average Revenue = TR/Q = (P  Q)/Q = P ♦Marginal Revenue =  total revenue from one more unit of output. ●Total, Average, and Marginal Revenue ♦Total Revenue = P  Q ♦Average Revenue = TR/Q = (P  Q)/Q = P ♦Marginal Revenue =  total revenue from one more unit of output.

TABLE 7-1 Demand for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 7-2 Total Revenue Curve for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved. TR A B C D E F G H I J 5 Total Revenue per Year (thousands $) Output, Garages Sold per Year

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Cost ♦The shapes of the cost curves mean that there is some size for the firm that is most efficient. ♦Firms that are smaller or larger than this optimal size will have higher average costs. ●Total, Average, and Marginal Cost ♦The shapes of the cost curves mean that there is some size for the firm that is most efficient. ♦Firms that are smaller or larger than this optimal size will have higher average costs.

TABLE 7-2 Al’s Total, Average, and Marginal Costs Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 7-3 (a) Cost Curves for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved. TC (a) Total Cost Output, Garages per Year 5 Total Cost per Year (thousands $)

FIGURE 7-3 (b) Cost Curves for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved. (b) Average Cost Output, Garages per Year 5 Average Cost per Garage (thousands $) AC

FIGURE 7-3 (c) Cost Curves for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved. MC (c) Marginal Cost Output, Garages per Year 5 Marginal Cost per Added Garage (thousands $)

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Total Profit: Keep Your Eye on the Goal ●Maximization of Total Profits ♦Profits typically increase with output, then fall. ♦Some intermediate level of output, therefore, generates the maximum profit. ●Maximization of Total Profits ♦Profits typically increase with output, then fall. ♦Some intermediate level of output, therefore, generates the maximum profit.

TABLE 7-3 TR, Costs, and Profit for Al’s Garages Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Marginal Analysis and Maximization of Total Profit ●Marginal profit is the slope of the total profit curve. ●Profit is at a maximum when the marginal profit is zero. ●Marginal profit is the slope of the total profit curve. ●Profit is at a maximum when the marginal profit is zero.

FIGURE 7-4 (a) Profit Maximization Copyright © 2003 South-Western/Thomson Learning. All rights reserved. TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

FIGURE 7-4 (b) Profit Maximization Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Marginal Analysis and Maximization of Total Profit ●Optimum Marginal Revenue and Marginal Cost ♦If MR > MC,  production   profits ♦If MR < MC,  production   profits ●Profit maximizing level out output: MR = MC ●Optimum Marginal Revenue and Marginal Cost ♦If MR > MC,  production   profits ♦If MR < MC,  production   profits ●Profit maximizing level out output: MR = MC

TABLE 7-4 Al’s Marginal Revenue and Marginal Cost Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 7-5(a) Profit Maxim: Another Graphical Interpretation Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Output, Garages per Year (a) Marginal Revenue and Marginal Cost 5 MR and MC per Garage per Year (thousands $) – MR MC E

FIGURE 7-5(b) Profit Maxim: Another Graphical Interpretation Copyright © 2003 South-Western/Thomson Learning. All rights reserved. TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

FIGURE 7-5(c) Profit Maxim: Another Graphical Interpretation Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Marginal Analysis and Maximization of Total Profit ●Finding the Optimal Price from Optimal Output ♦MR = MC: rule for determining the level of output ♦Demand curve  price buyers will pay to purchase that level of output ♦Both output and price are now determined for the profit maximizing firm. ●Finding the Optimal Price from Optimal Output ♦MR = MC: rule for determining the level of output ♦Demand curve  price buyers will pay to purchase that level of output ♦Both output and price are now determined for the profit maximizing firm.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Logic of Marginal Analysis & Maximization ●If a decision is to be made about the quantity of some variable, then maximize net benefit. ●Net benefit = total benefit - total cost ●To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost. ●If a decision is to be made about the quantity of some variable, then maximize net benefit. ●Net benefit = total benefit - total cost ●To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Logic of Marginal Analysis & Maximization ●Application: Fixed Cost and Profit Maximization ♦An increase in fixed costs does not change optimal output or price because it does not affect marginal costs. ●Application: Fixed Cost and Profit Maximization ♦An increase in fixed costs does not change optimal output or price because it does not affect marginal costs.

TABLE 7-5 Rise in Fixed Cost: Total Profits Before and After Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 7-6 Fixed Cost Does Not Affect Profit-Maximizing Output Copyright © 2003 South-Western/Thomson Learning. All rights reserved Profit with a fixed cost Profit with zero fixed cost N Total Profit per Year (thousands $) Output in Garages per Year M

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Fundamental Role of Marginal Analysis ●Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results. ●For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost. ●Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results. ●For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Fundamental Role of Marginal Analysis ●Any problem involving optimization can be illuminated with marginal analysis. ●The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses. ●Any problem involving optimization can be illuminated with marginal analysis. ●The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Theory and Reality: A Word of Caution ●Business people seldom use marginal analysis in a literal sense. ●They often rely on intuition and hunches. ●But these theories can be used to understand and predict behavior. ●Business people seldom use marginal analysis in a literal sense. ●They often rely on intuition and hunches. ●But these theories can be used to understand and predict behavior.

Appendix: Relationships Among Total, Average, and Marginal Data

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●Average = total  the number of units ●Total = average  the number of units ●Average = total  the number of units ●Total = average  the number of units Relationships Among Total, Average, and Marginal Data

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Relationships Among Total, Average, and Marginal Data ●Marginal value of the xth unit = total value of x units - total value of (x - 1) units. ●Total value of x units =  marginal values of the first x units. ●Marginal value of the xth unit = total value of x units - total value of (x - 1) units. ●Total value of x units =  marginal values of the first x units.

TABLE 7-6 Weights of Persons in a Room (in pounds) Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ●The marginal, average and total values for the first unit are usually equal. ♦If marginal < average, the average is falling. ♦If marginal > average, the average is rising. ♦If marginal = average, the average is constant; that is, the average is at a maximum or minimum. ●The marginal, average and total values for the first unit are usually equal. ♦If marginal < average, the average is falling. ♦If marginal > average, the average is rising. ♦If marginal = average, the average is constant; that is, the average is at a maximum or minimum. Relationships Among Total, Average and Marginal Data

FIGURE 7-7 Relationship between Marginal and Average Curves Copyright © 2003 South-Western/Thomson Learning. All rights reserved. F E A D B C Average weight Marginal weight Marginal and Average Weight (pounds) Number of Persons