Optimal Decision Making in Business: Marginal Analysis Essentials

1. Chapter 8 Output, Price, and Profit: the Importance of Marginal Analysis Business is a good game. . . . You keep score with money. NOLAN BUSNELL

2. Price & Quantity: One Decision • Optimal decision • Best - among possible decisions • Firm - Select price • Quantity – consumers • Firm - Select quantity • Price – market • Firm’s demand curve • Price-quantity pairs

3. Figure 1 Demand curve for Al’s garages D a 35 30 b 25 Price per Garage (thousands $) c 19 22 26 16 20 d Profit maximum e f g h 15 i j D 10 7 9 1 3 5 0 2 4 6 5 Output , Garages Marketed per Year 8 10

4. Total Profit: Keep Your Eye on the Goal • Firm’s objective • Maximize total profit • Total profit = Net earnings • Total revenue • Minus total cost • Include: opportunity cost • Economic profit

5. Opportunity cost and profit • Economic profit • Total revenue • Minus total cost • Include: opportunity costs • Inputs supplied by firm’s owner • Accountant’s profit • Gross receipts – Gross costs

6. Economic Profit & Optimal Decision Making • Price & quantity decision • Economic profit > 0 • Optimal decisions • Economic profit = 0 • Satisfactory decisions • Economic profit < 0 • Not optimal

7. Economic Profit & Optimal Decision Making • Economic profit • Accounting profit • Minus opportunity cost • Accounting profit: best alternative • Total revenue (TR) • Total amount of money • From buyers • No deduction of costs • TR = P ˣ Q

8. Table 1 Demand for Al’s garages: his total revenue schedule and his marginal revenue schedule $30 26 22 18 14 10 6 2 -2 -6

9. Economic Profit & Optimal Decision Making • Average revenue (AR) • Total revenue • Divided: quantity • AR = TR/Q = P ˣ Q / Q = P • Marginal revenue (MR) • Addition to total revenue • From one more unit of output • MR = slope of TR curve • MR1 = TR1 – TR0

10. Figure 2 Total revenue curve for Al’s garages A 140 TR 120 B 100 C 80 D Total Revenue per Year (thousands $) F G H 60 I J E 40 7 9 1 3 5 0 2 4 6 20 Output , Garages Sold per Year 8 10

11. Economic Profit & Optimal Decision Making • Total cost (TC) • Average cost (AC) • U-shaped • Marginal cost (MC) • U-shaped

12. Table 2 Al’s total, average, and marginal costs $28 16 10 8 6 7 9 16 32 46

13. Figure 3 (a) Cost curves for Al’s garages; (a) Total Cost 200 TC 180 160 140 120 Total Cost per Year (thousands $) 100 80 60 40 7 9 1 3 5 0 2 4 6 20 Output , Garages per Year 8 10

14. Figure 3 (b) Cost curves for Al’s garages; (b) Marginal Cost 50 MC 45 40 35 30 25 Marginal Cost per Added Garage (thousands $) 20 15 10 7 9 1 3 5 0 2 4 6 5 Output , Garages per Year 8 10

15. Figure 3 (c) Cost curves for Al’s garages; (c) Average Cost 45 40 35 30 AC 25 Average Cost per Garage (thousands $) 20 15 10 7 9 1 3 5 0 2 4 6 5 Output , Garages per Year 8 10

16. Economic Profit & Optimal Decision Making • Maximize total profit • Total revenue • Minus total cost • Graphically • Vertical distance • TR curve • TC curve • Same slope • Total profit curve

17. Table 3 Total revenues, costs, and profit for Al’s garages $2 10 12 10 8 3 -3 -14 -34 -52

18. Figure 4 (a) Total Revenue. Total Cost Profit maximization: A graphical interpretation TC 200 180 $22,000 Maximum profit 160 M A 140 B 120 TR Total Revenue, Total Cost per Year (thousands $) 96 100 74 80 60 40 7 9 1 3 5 0 2 4 6 20 Output , Garages per Year 8 10

19. Figure 4 (b) Total Profit Profit maximization: A graphical interpretation Maximum profit M 40 E F C D 20 0 34 Total Profit per Year (thousands $) -20 -40 -60 7 9 1 3 5 2 4 6 -80 8 10 Output , Garages per Year

20. Marginal Analysis & Max. Total Profit • Marginal profit • Addition to total profit • From one more unit of output • Optimal level of output • Marginal profit > 0 • Increase output • Marginal profit < 0 • Decrease output • Marginal profit = 0 • Optimal output

21. Important: thinking at the margin • Marginal analysis • Marginal cost vs. Marginal benefit • Optimal decisions • Marginal analysis • Business firm - maximize total profit • Consumer - maximize utility • Country - maximize per-capita output • Input proportions • Advertising • Output levels and prices

22. Marginal Analysis & Max. Total Profit • Marginal revenue (MR) • Slope of TR curve • Marginal cost (MC) • Slope of TC curve • Maximize profit • Output quantity: MR=MC • Price: demand curve

23. Table 4 Al’s marginal revenue and marginal cost

24. Figure 5 (a) Marginal Revenue & Marginal Cost Profit maximization: another graphical interpretation MC 50 E 40 30 20 MR and MC per Garage per Year (thousands $) 10 MR 0 7 9 1 3 5 2 4 6 -10 8 10 Output , Garages per Year

25. Figure 5 (b) Total Revenue & Total Cost Profit maximization: another graphical interpretation TC 200 180 $22,000 Maximum profit 160 M A 140 B 120 TR Total Revenue, Total Cost per Year (thousands $) 96 100 74 80 60 40 7 9 1 3 5 0 2 4 6 20 Output , Garages per Year 8 10

26. Figure 5 (c) Total Profit Profit maximization: another graphical interpretation Maximum profit M F 40 E C D 20 0 34 Total Profit per Year (thousands $) -20 -40 -60 7 9 1 3 5 2 4 6 -80 8 10 Output , Garages per Year