In class, we were studying profit maximization, where we kept looking at graphs like the one below.
Here, production was on the marginal cost curve and, if it was above the average total cost, there was profit and, if it was below it, there were losses. (There was also a average variable price, which isn’t pictured here) What confused me was why production is always on the marginal cost curve. I decided to do some research and I found a pretty simple explanation.
The second image shows only MC and MR from the first graph. There is another value, marginal profit, which isn’t pictured, which is equal to marginal revenue minus marginal cost. There are three possibilities for production, where MC<MR, MC=MR, and MC>MR. We always produce at MC=MR. If MC>MR, then the company loses money, since it pays more than it makes, which is straightforward enigh. That company will, logically, make less product until MC=MR. When MC<MR, the company is making money, which seems ideal. Logically, a company could produce at MC<MR. However, when the company is making money, it will increase production. This will cause the quantity to go up until it will eventually reach MC=MR.
Just to summarize, a company’s price, or marginal revenue, will always approach marginal cost. At that point, a company will be making exactly as much money as creating another unit would cost and their marginal profit will equal to zero.
Great post! This definitely helped me grasp why especially a company wouldn't produce at MC<MR if it seemed ideal. I had difficulty understanding how this wasn't sustainable. This reminded me of an event we learned about in US history during the Great Depression, where many farmers who were short on money would produce more crops in an attempt to make more. However, because marginal revenue decreased significantly, the farmers actually lost money when they produced more. President Franklin Roosevelt attempted to solve this problem by enacting the Agricultural Adjustment Act, which paid farmers to lessen production and even sometimes destroy their crops. He hoped that by lowering supply enough, farmers would be able to make more money. While this does seem like a solid plan, the act was deemed unconstitutional because it allowed the federal government to interfere with state issues.
ReplyDeleteGreat post Anna! This really helps me to understand why companies produce at MC=MR and how this is reached after they used the additional profits from producing at MC<MR. I find it interesting to observe this in real life when companies are just starting out and how they can use the money to expand and eventually reach MC=MR by either creating more product or opening up a new location/ production site. Thanks again for a great post!
ReplyDeleteThis is an exceptional post. I love how you simplify the relationship between MC and MR. Additionally, your summary at the end is very insightful.
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