A. Define marginal revenue. Explain its relationship with total revenue.
Marginal revenue can be defined as an increase in revenue that is produced by the sale of one output unit. It can be calculated as a ratio of the change in total revenue to the change in the total output. In the perfectly competitive market marginal revenue is equal to the selling price. In the monopolistic market, however, as supply is controlled by only one company, demand curve is usually above the marginal revenue curve, thus allowing the company to charge higher prices and gain additional revenues.
B. Define marginal cost. Explain its relationship with total cost.
Marginal cost is the cost that is incurred in the production of one additional unit of output. It is calculated as a ratio between the change in total cost and the change in total output.
C. Define profit. Explain the concept of profit maximization.
Profit can be defined as the financial benefit that is obtained if the revenues gained by the business exceed the costs associated with its activities (Definition of 'Profit'). Profit maximization is often considered the ultimate goal of the company and refers to the process of optimization of costs and revenues in order to achieve the maximum level of profit. There are several approaches to finding the point of maximum profit. Marginal analysis suggests that the company will obtain maximum profits at the point, where marginal revenues equal marginal costs. In a perfectly competitive market this point shows both the optimal level of output for the company and the most favourable price. If the firm operates as a monopoly in the market its optimal output and the level of maximum profit can still be determined by the intersection of marginal cost and marginal revenue curves, however, the optimal price is set above that indicated by the marginal revenue level.
D. Explain how a profit-maximizing firm determines its optimal level of output, using marginal revenue and marginal cost as criteria.
Profit-maximizing firm can determine its optimal level of output by using marginal cost and marginal revenue curves. As it has been discussed above, companies maximize their profits at the point of intersection of marginal cost and marginal revenue curves. In a perfectly competitive market the point of intersection of these curves indicates the price level as well as the optimal level of output that maximize company’s profits.
E. Explain what action a profit-maximizing firm takes if marginal revenue is greater than marginal cost.
In case marginal revenue exceeds marginal cost, there is an incentive for a profit-maximizing company to continue producing the item. An increase in production will lead to higher revenues due to the margin obtained through the difference between marginal cost and marginal revenues. As the costs of producing one extra unit will increase due to various factors, such inefficiencies and resource depletion, or as the price for the product goes down due to higher market supply, marginal cost and marginal revenues will be converging to reach the level where the two values are equal. At this point the company maximizes its revenue and produces the optimal level of output. Further increase of production will destabilize the equilibrium, as marginal revenues
F. Explain what action a profit-maximizing firm takes if marginal revenue is less than marginal cost.
If marginal revenue is less than the marginal cost, the company is producing every item at a loss. Other things being equal, in a perfectly competitive market companies should stop producing at this point. The situation is less critical in case of a monopolistic market, as selling price is not equal to marginal revenues and companies can continue producing even if their marginal revenues are below marginal costs. However, a profit-maximizing firm can take several steps to improve its position. The first option is to lower its costs by becoming more efficient or eliminating non-value-adding steps. This approach would allow equalizing marginal cost and marginal revenue, thus maximizing profit. An alternative solution could be to enhance product quality or to win over the competition, in order to increase marginal revenue to the point, where it is equal to marginal cost.
References
Definition of 'Profit'. In Investopedia Retrieved from
http://www.investopedia.com/terms/p/profit.asp#axzz2ApSscIxH
