Introduction

We can now represent the profit maximisation position of Funky Chicken graphically. For this purpose, we will only use the quantity, marginal revenue and marginal cost data as indicated in the table below.

Marginal cost and revenue for Funky Chicken.

The firm maximises profits at point E where marginal revenue is equal to marginal cost. The output level at this point is 80.

Quantity (units of fried chicken)

Q

 Marginal cost

MC

(rand)

 Marginal revenue

MR

(rand)
10 2,80 4,00
20 2,00 4,00
30 1,60 4,00
40 1,80 4,00
50 2,20 4,00
60 2,60 4,00
70 3,40 4,00
80 4,00 4,00
90 6,00 4,00
100 8,00 4,00
By combining the points we get the MC curve By combining the points we get the MR curve

The firm maximises profits at point E where marginal revenue is equal to marginal cost. The output level at this point is 80.

Consider an output level of 60 in the following diagram:

 

  • What is the marginal revenue at this output level?
  • What is the marginal cost at this output level?
  • Should the firm increase or decrease its production?
Click to Show Answer

At an output level of 60, the marginal revenue is R4,00 and the marginal cost is R2,60. Since marginal revenue is greater that marginal cost, Funky Chicken should increase its production because the additional units produced add to the firm's profits.

Consider an output level of 90 in the following diagram:

 

  • What is the marginal revenue at this output level?
  • What is the marginal cost at this output level?
  • Should the firm increase or decrease its production?
Click to Show Answer

At an output level of 90, the marginal revenue is R4,00 and the marginal cost is R6,00. In this case, the profits from Funky Chicken decrease since it costs R6,00 to produce the additional unit. However, the revenue from it is only R4,00, and there is a loss of R2,00. By decreasing its production, Funky Chicken can increase its profits.

Levels of output to the right of 80, where MR < MC, indicate that marginal revenue is less than marginal cost, and it is in the interest of the firm to decrease its production in order to increase its profits.

Levels of output to the left of 80, where MR > MC, indicate that marginal revenue is greater  than marginal cost, and it is in the interest of the firm to increase its production in order to increase its profits.

To summarise, we can conclude the following:

The firm maximises profits if it produces the quantity where the marginal revenue (MR) is equal to the marginal cost (MC).

If MR = MC, then there is profit maximisation.

If MR > MC, then profits increase.

The reason for this is straightforward. For as long as the marginal revenue is greater than the marginal cost, the marginal revenue contributes towards total profits. By producing and selling an additional unit, the producer gains more than it costs to produce the additional unit, and its profits increase.

If MR < MC, then profits decrease.

When marginal revenue is less than marginal cost, total profits will decline. It is costing the firm more to produce the additional unit than it obtains from selling the additional unit. It is therefore not in the interest of the firm to produce the extra unit because this decreases its profits.

Activity

Each graph indicates the output which the ice cream factory is currently producing. Based on the following graphs, what should the firm do to its output in each instance if it wishes to maximise its profits?

1.

Correct. Expand output. Since marginal revenue is greater than marginal cost, the firm can increase its profits by producing more.

Think again. Expand output. Since marginal revenue is greater than marginal cost, the firm can increase its profits by producing more.

Think again. Expand output. Since marginal revenue is greater than marginal cost, the firm can increase its profits by producing more.

2.

Think again. Leave output unchanged. Since marginal revenue is equal to marginal cost, the firm is maximising profits. If it expands production, its profits will decrease.

Correct. Leave output unchanged. Since marginal revenue is equal to marginal cost, the firm is maximising profits. If it expands production, its profits will decrease.

Think again.

Leave output unchanged. Since marginal revenue is equal to marginal cost, the firm is maximising profits. If it expands production, its profits will decrease.

3.

Think again. Reduce output. Since marginal revenue is smaller than marginal cost, the firm should reduce its output in order to increase its profits.

Think again. Reduce output. Since marginal revenue is smaller than marginal cost, the firm should reduce its output in order to increase its profits.

Correct. Reduce output. Since marginal revenue is smaller than marginal cost, the firm should reduce its output in order to increase its profits.