Does Profit Maximization Occur Where Marginal Cost Is Equal to Marginal Revenue?
All people make decisions “at the margin,” and business owners are no exception. Decisions to sell one more unit, produce one more run or make one more photo shoot are all decisions that are made at the margin. The decision process weighs the pros (marginal benefits) and the cons (marginal cost). When these two things are equal, it means you are maximizing profit.
Marginal revenue is the additional revenue that a business earns when it sells one more unit. Many firms can sell as much as they can produce without having to change the price. Economists tell us that those firms are in perfect competition and that the demand for their products is perfectly elastic. For other firms, increasing production means cutting the price to move the products. In either case the marginal revenue will be the price of the last unit sold.
The marginal cost is the amount it takes to produce one more unit, which includes labor and material cost and the costs associated with that unit’s production. These are metrics that can be estimated with reasonable accuracy. Labor time and cost are measurable, as are material costs. Overhead does not factor into the figure, since it is fixed and is independent of the unit production.
Marginal analysis involves looking at the effect of producing that additional unit of output. At low levels of production it is likely that marginal revenue is greater than marginal cost. By producing more, a business adds to its profits, because each successive unit adds more to the revenue than it does to its cost. Eventually, however, marginal cost will begin to rise as production costs go up. When marginal cost rises to equal marginal revenue, the firm will be maximizing its profit. In the unlikely event that a business reaches a production level where its marginal cost is greater than marginal revenue, it should cut production back to the point where the two metrics were equal.
Consider a full-service restaurant. If the average meal price is $15, that figure is the marginal revenue. As long as it costs less than $15 to prepare that meal, the restaurant will continue to sell as many as it can. But if the cost to prepare and serve the meal costs more than $15, the restaurant has three choices: cut back on its menu, raise the price of the meal (raising the marginal revenue) or send several of the workers home for the day (to lower the marginal cost). A retail shop that sells shoes for $50 a pair has a marginal revenue of $50. As long as the cost of selling each pair is less than that, the store will sell all it can, since each sale adds more profit. But if the marginal cost of a pair rises above $50 -- possibly because brisk sales led to hiring too many salespeople -- then the owner should downsize to restore profitability.