Marginal revenue and Marginal cost approach

The second method of showing equilibrium of the firm is in terms of marginal revenue and marginal cost curves.

There are three condition that must be satisfied for the profits to be maximum.

Rule 1 :

In the short run, a firm should produce 

if and only if P or AR > AVC  OR TR > TVC

1) A firm has to incur fixed cost even if there is no production, firm sometimes continues to produce even when it is facing losses.

If a firm decides to shut down and produce nothing, the losses would be equal to its fixed cost.

2) A profit earning firm will never lose more than its fixed cost, if the revenue is so low that the firm is unable cover its variable cost, to avoid this cost a firm can stop (cease) production, but if the firm still has the capital to resume production later, 

so this is a situation of Shut down ( a firm produce no output to minimise its lose).

3) So in a situation of shut down, the loss is equal to firm’s fixed cost.

4) When losses in production < losses in shut down, a firm will decide to produce otherwise close down production.

5) The firm will produce output only when P(price) or AR(average revenue)[in perfect competion P= AR] is covering at least the AVC(average variable cost) because in that case losses in production would be equal to or less than losses in case of shut down.

6) If the P = AVC, it means that the firm is covering only variable costs, and it is not able to cover fixed cost at all. In this situation, losses in both the situations 

(production or shut down) would be the same and would be equal to fixed cost.

7) If the P > AVC, then he is covering entire variable costs and part of fixed costs as well. Here, losses in production would be less than losses in case of shut down, and the firm will definitely produce.

As shown by the below graph:

short run curve

As explained above, SAC lies above the price ( P= AR= MR), the firm is incurring losses shown by the shaded area. Since price exceeds AVC, the firm continues to produce in the short run.

So this is the first rule. A rule to decide whether or not to produce in the short run. 

Rule 2 :

A necessary condition for the firm to be producing its profit maximizing output is that the marginal revenue(MR) should be equal to the marginal cost (MC)

After deciding that the firm will produce or not, then the firm has to decide as to how much should it produce. 

It will produce till that amount where profit is maximum. 

Profit maximisation output would be the one which equates marginal revenue with marginal cost i.e MR = MC

Why at  MR = MC profit is maximum?

When MR >MC

It means that cost of producing one more unit (MC) is less than the additional revenue (MR), meaning that the firm can sell more by selling more units of output, additional unit produced adds to profits.

Thus, if MR >MC the firm can increase its profits by producing more.So this would be not an equilibrium situation.

When MR <MC

It means that cost of producing one more unit (MC) is more than the additional revenue (MR), meaning that the firm cost of producing another unit is more than the additional revenue that can be earned by selling that unit,it means that additional unit produced reduces profits.

Thus, if MR < MC the firm can increase its profits by producing less.So this would be not an equilibrium situation.

So, it follows that whenever marginal cost does not equal to marginal revenue, the firm can increase its profits by producing more (when MR > MC) or producing less (when  MC > MR).

But if MC = MR, then it does not pay the firm to produce either more or less. Therefore it follows the second rule (rule 2).

Rule 3:

For equality of marginal cost with marginal revenue to ensure profit- maximisation rather than profit-minimisation, it is sufficient that the marginal cost be less than marginal revenue at slightly lower output and that the marginal cost exceeds marginal revenue for slightly higher output i.e MC curve should intersect MR curve from below.

As explained by the below graph:

marginal revenue

To find that what will be the profit maximisation output and not profit minimisation output.

Here MC = MR at two levels of output, i.e. OQ and OQ₁ level of output..

OQ output is minimum profit position. At OQ level of output, the firm is able to cover its cost for the first time. R is therefore break – even point. 

But if the firm want to expand its output beyond OQ, it still is earning profit since MR > MC.The firm will  not stop at OQ level of output.

So, point R (where MC curve cuts MR curve from above) cannot be the point of equilibrium.

OQ₁ is profit maximisation output, since a change in output in either direction would reduce profits.

Before OQ₁ level of output, MC < MR and profit can be increased by increasing output towards OQ_1.

Beyond OQ₁ , MC > MR and profit can be increased by reducing output towards OQ₁.

Thus, point K is the point of equilibrium.

MC curve should intersect MR curve from below as shown br point K.

MC is less than MR to the left of profit maximisation output and greater than MR to the right of the profit maximising output.