Practical Applications of Marginal Analysis

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IKT434 Topics in Economics

Managerial Economics
Practical Applications of Marginal Analysis The most common use of marginal analysis is to find the profit maximizing activity level. To show how this is done, consider the following case of Storrs Manufacturing Company.

Case Study: Storrs manufacturing company Storrs manufacturing company is located in Ankara. The company has developed and test-marketed the “Golden-Bear Golf Cart”, a newly and highly energy efficient golf cart. The product is unique and preliminary indications are that Storss can obtain a substantial share of the national market if it acts quickly to expand production from its current level of 400 units per month. Data from independent marketing consultants retained by Storrs indicate the following monthly demand, total revenue and marginal revenue relations:

P = 7500 − 3 . 75 Q

Demand Total revenue Marginal revenue

TR = 7500 Q − 3 .75 Q 2
MR = 7500 − 7 . 5 Q
Where p is price and Q is output.

Storrs accounting department has estimated monthly total cost and marginal cost relations as follows:

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IKT434 Topics in Economics

TC = 1 .012 .500 + 1500 Q + 1, 25 Q 2

MC = 1500 + 2 , 5 Q
Given these data, a.) What is the profit maximizing optimal production level of this company? b) What is the total profit of this firm at this activity level?

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IKT434 Topics in Economics

1. Profit Maximisation: We know that the activity level maximising profit is where MR=MC. If; MR = MC

7500 − 7 ,5Q = 1500 + 2 ,5Q

10Q = 6000
level)

Q = 600 units (profit maximising output

P = 7500 – 3,75 Q P = 7500 – 3,75 * 600 P = 5250 TL

Π = TR − TC
Π = 7500Q − 3,75Q 2 − 1.012.500 − 1500Q − 1,25Q 2
Π = 787.500 TL

2. Revenue Maximisation: Firms do not always aims profit maximisation. Especially, the sectors where profit margins are quite high always attract the new firms. One way to prevent the entrance of new firms into such markets is to target short run revenue maximisation rather than profit maximisation. This will enable the firm control a great portion of the market and preclude entry by new rivals. In fact, this short run policy is a part of long run value maximisation strategy. How would the results change if Storrs in the previews example had aimed at revenue maximisation rather than profit maximisation?

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IKT434 Topics in Economics

The total revenue of a firm is maximised if marginal revenue is equal to Zero. Then, MR = 0 7500 – 7,5Q = 0

Q * = 1000 unit
level)

(revenue maximising output

P * = 7500 − 3,75 * 1000

P * = 3750 YTL
Π = TR – TC = - 12.500 (loss)

Notice that revenue maximisation strategy involves consideration of revenue (or demand side) influences only. Unlike profit maximisation, the cost of generating output was not taken into account. Profit maximisation, on the other hand, considers both demand side and cost relations.

3. Average Cost Minimisation Profit and revenue maximisations may be the most common uses of marginal analysis, but there are still some other short run strategies for the firms. An intermediate strategy of expanding output in the short run would be “average cost minimisation”. Consider again the Storrs Company, and assume that it decide on the average cost minimisation strategy. To find the activity level, remember that

If

MC > AC MC < AC MC = AC

raising average cost falling average cost average cost is at the minimum.

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IKT434 Topics in Economics

Therefore, the average cost minimizing activity level can be found as follow:

TC 1.012.500 + 1500Q + 1,25Q 2 = AC = Q Q
AC =

1.012.500 + 1500 + 1,25Q Q
MC = AC

For Min AC Then;

1500 + 2,5Q =

1.012.500 + 1500 + 1,25Q Q

1,25Q =

1.012.500 Q

Q * = 900 unit

P * = 7500 − 3,75 * 900
P * = 4.125 TL

Π = −5 * (900 2 ) + 6000 * (900) − 1.012.500

Π = 337.500 TL
Average cost minimisation involves operation at an activity level that lies between those indicated by profit and...
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