- A. Profit Maximization
In order for Company A to be successful, it must produce the optimal amount of widgets to achieve maximum profits at all levels. There are two ways to determine this (McConnell, Brue, & Flynn, 2012).
Total Revenue to Total Cost (TR/TC)
This method is concerned with overall levels of price and production. TR is determined by how many widgets are produced multiplied by how much each widget is sold for (price x quantity). TC is determined most simply by combining the average fixed costs and the average variable costs for producing any specific amount of widgets (AFV + AVC). Profits are then determined by subtracting total costs from total revenues at various production levels. Profits are maximized by discovering the point where the gap between the two is largest on the revenue side.
Marginal Revenue to Marginal Cost (MR/MC)
This method of determining profit maximization focuses on the changes made by adding or subtracting individual units. MR and MC is the difference each additional unit makes to total revenue or cost. In other words, MC (or MR) is the change in total cost (or revenue) divided by the quantity. Profit maximization occurs where MR equals MC.
- B. Marginal Revenue Calculations
Based on the changes in total revenue, MR is greatest at the quantity of one and diminishes steadily as quantity increases. This can be seen in the chart how MR decreases by $10 for every unit after the first. That is to say, MR decreases steadily as production and sales increase. This shows that Company A exists in a Monopolistically Competitive environment and must offer discounts at each level of production to maintain demand. MR is derived from the difference in revenue from each additional unit. In other words, MR is calculated as the change in TR from adding one more widget to production and selling it. The formula for this is MR=change in TR/change in quantity.
- C. Marginal Cost Calculations
Referring again to the chart above, it is seen that MC is constant from one unit to two and then increases steadily throughout the production range. This shows the fixed cost of $10 and a variable cost of $10 through the second unit whereupon the MC increases steadily with each successive unit. MC is calculated by determining the difference in TC from adding each additional widget. The formula for this is MC=change in TR/change in quantity.
- D. Point of Profit Maximization
From the given data, it is seen that from the perspective of TR/TC, maximum profits of
$540 are achieved at eight units. The MR/MC chart included here corroborates this conclusion as it is seen that MR equals MC at eight units.
- E. Adjusting Output 1
If it is discovered during marginal analysis that MR exceeds MC, then production should be increased to the point where MR is equal to MC, or as close to that as possible on the positive side.
- F. Adjusting Output 2
On the other hand, if it turns out that MC exceeds MR, then this means the company is losing money and losses need to be minimized by restricting output to the point where MR equals MC, or as close as possible on the positive side.
McConnell, C. R., & Brue, S. L., Flynn, S. (2012). Economics (19th ed., pp. 141-238). McGraw-Hill.