Question

Why is the equality between marginal cost and marginal revenue necessary for a firm to be in equilibrium?

Answer 1

How Can Marginal Revenue Increase?

Marginal revenue increases whenever the revenue received from producing one additional unit of a good grows faster (or shrinks more slowly) than its marginal cost of production. Increasing marginal revenue is a sign that the company is producing too little relative to consumer demand, and there are profit opportunities if production expands.

Let's say a company manufactures toy soldiers. After some production, it costs the company $5 in materials and labor to create its 100th toy soldier. That 100th toy soldier sells for $15. Profit for this toy is $10. Now, suppose the 101st toy soldier also costs $5, but this time can sell for $17. The profit for the 101st toy soldier, $12, is greater than the profit for the 100th toy soldier. This is an example of increasing marginal revenue.

For any given amount of consumer demand, marginal revenue tends to decrease as production increases. In equilibrium, marginal revenue equals marginal costs; there is no economic profit in equilibrium. Markets never reach equilibrium in the real world; they only tend toward a dynamically changing equilibrium. As in the example above, marginal revenue may increase because consumer demands have shifted and bid up the price of a good or service.

It could also be that marginal costs are lower than they were before. Marginal costs decrease whenever the marginal revenue product of labor increases – workers become more skilled, new production techniques are adopted, or changes in technology and capital goodsincrease output.

Marginal Analysis

All these calculations are part of a technique called marginal analysis, which breaks down inputs into measurable units. First developed by economists in the 1870s, it gradually became part of business management, especially in the application of the cost-benefit method – the identification of when marginal revenue is greater than marginal cost, as we've been explaining above. According to the cost-benefit analysis, a company should continue to increase production until marginal revenue is equal to marginal cost.

If optimal output is where marginal benefit is equal to marginal cost, any other cost is irrelevant. So marginal analysis also tells managers what not to consider in making decisions about future resource allocation: They should ignore average costs, fixed costs and sunk costs.

For example, a toy manufacturer could try to measure and compare the costs of producing one extra toy with the projected revenue from its sale. Suppose that, on average, it has cost the company $10 to make a toy. The average sales price over the same period is $15. This doesn't necessarily mean that more toys should be manufactured, however. If 1,000 toys were previously manufactured, then the company should only consider the cost and benefit of the 1,001sttoy. If it will cost $12.50 to make the 1,001sttoy, but it will only sell for $12.49, the company should stop production at 1,000.