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Production Theory
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Determining Profit Maximizing Level of Production -- Marginal Cost and Marginal Revenue
Maximum profit is the level of output where MC equals MR.
As long as the revenue of producing another unit of output (MR) is greater than the cost of producing that unit of output (MC), the firm will increase its profit by using more variable input to produce more output.
The law of (the reality of) diminishing marginal productivity demonstrates that adding input will eventually reduce production and increase cost. When the production level reaches a point that cost of producing an additional unit of output (MC) exceeds the revenue from the unit of output (MR), producing the additional unit of output reduces profit. Thus, the firm will not produce that unit.
Profit is maxmized at the level of output where the cost of producing an additional unit of output (MC) equals the revenue that would be received from that additional unit of output (MR).
- Maximum profit is not maximum productivity unless cost of variable input is zero (variable input is free), or price of output is infinite; since neither of these is likely to occur, we can confidently state that maximum profit is not earned by maximizing production. Restated, MC is infinite where production is maximized. MR would need to be infinite to maximize profit where production is maximized. Since no one will pay us an infinite price for our product, MC will equal MR at a level of production that is less than maximum production.
An example to illustrate the impact of technology
An advance in technology shifts the TPP curve; it also shifts the TVC curve (usually lowering the TVC). However, acquiring new technology probably means incurring a fixed cost which shifts the TFC curve (usually raising the TFC). The manager needs to decide whether the increase in TFC due to adopting technology is adequately offset by the reduction in the TVC to justify investing in the new technology.
In summary
- Profit is NOT maximized at maximum production.
- Advances in production technology increases output from the same level of variable input.
- The MC cost is the firm's supply curve for the output.
The next section describes how marginal cost illustrates the firm's supply of the output.
Last Updated September 14, 2010
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
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