Marginal Analysis Marginal Costs

The businessman may also approach his out- put decision another way. First, remember that he must take the market price of $1,800 as given by the market. Now look again at his cost data. Some of the businessman’s decisions arc big ones—to operate or shut down, for example. Most of his decisions, however, are marginal ones—to take this new order at the going price or to refuse it; to cut back output 5 per cent or 10 per cent as price falls or unsold inventory piles up. In such decisions, how much additional cost is involved in expanding output moderately, or how much is saved by cutting output a little, becomes of spe- cial interest. The concept of “marginal cost,” or “incremental cost,” has been developed to help in this kind of analysis.

Marginal cost is the addition, or increment, to total cost involved in expanding output by one unit. For example, going back to the hi-fl cost data in Table 22-1, if the total cost of producing three sets per month is $4,000 and that of pro- ducing four sets $5,000, the marginal cost of ex- panding production from three to four units is $1,000. That’s how much extra it costs us to get the fourth set produced.2 This calculatioti is shown in Table 23-2.

Most economic adjustments are marginal adjustments of some sort. Comparison of gains and losses “at the margin”—for example, com- parison of the marginal income and marginal cost associated with increasing output from four to five sets monthly—is the core of intelligent decision- making, in economics as elsewhere. The principle is the same as when you weigh the advantages of another hour’s study before an exam against the disadvantages of giving up the hour’s sleep. Appli- cations abound in every field. In building a bridge, for example, the engineer must constantly weigh the advantages of getting increased strength against the related disadvantages of incurring ad- ditional weight and expense.

Mcimizing Prollts in the Short Run :
MnrginaI Costs and Morginal Revenue

Table 23-3 reproduces the cost data for the hi-fl firm from Chapter 22, adding a column to show the marginal cost involved in increasing out- put by one set at each stage. This is simply the last column of Table 23-2 above. With the market price at $1,800, how many sets per month should we produce? Try to figure it out for yourself, by comparing how much we add to costs and to in- come as we increase output.

The answer again is six—neither more nor less. The figures for six sets are underscored in the table. The marginal-cost column tells how much extra is added to total costs by increasing output one more unit. Now compare this with the extra income produced by each additional unit sold. Each unit we produce brings in $l,800.~ This concept of incremental income is similar to the concept of marginal cost. Economists call the $1,800 added to total revenue by each additional set sold the “marginal revenue.” Marginal revenue is the extra revenue added by the sale of one more unit.

So long as producing more units adds more to total revenue than to total costs, it pays to keep on increasing output. This is the same as saying that it will pay to keep on increasing output so long as marginal revenue is larger than marginal cost. At all levels of output up to and including six, producing another unit adds less than $1,800 to costs, but $1,800 to revenues. But producing the seventh unit would add an extra $3,400 to costs, and only $1,800 to revenue. Clearly we would be foolish to produce the seventh unit.

What is the total profit at six units? Total cost is about $7,600 (average unit cost of $1,267 times six sets). Total revenue is $10,800 (price of $1,800 per set times six sets). Profit is thus $3,200. This is, of course, identical to the answer obtained by comparing total costs and total revenues in Table 23-1.

The principle is: Profit will be maximized by carrying production up to the point where mar- ginal cost equals marginal revenue (here, the price), and no further.

Ask yourself one more question, to be sure you understand. Wouldn’t we be better off to produce seven units instead of six, getting the profit on the seventh, since the $1,800 price ex- ceeds the total unit cost of $1,573 at seven units of output? The marginal-cost—marginal-revenue comparison gives the answer. The seventh set adds $3,400 to total cost and only $1,800 to total revenue. The fact that price is above total unit cost tells us that we can make a profit at that out- put level, but not that we will make our maximum profit at that level. Trying to pick up the profit on a seventh set would be a mistake, since it would actually involve adding more to cost than to revenue; total unit cost would be higher on all seven units if we increase output to seven. Com- pute the total profit at seven units and you’ll see that it’s only about $1,600 ($12,600 revenue less cost of about $11,000), less than at six units.