Managerial Economics: A Case Study

To explain the equation p=MC(q), it is important to first understand what marginal costs are and how they are calculated. Marginal costs are the change in the total cost that arises when incrementing production by one unit, that is to say it is the cost of producing one more unit (Lipsey & Harbury, 1992). Total costs are calculated by adding the variable and fixed costs. Variable costs are costs that depend on a company’s production volume, they rise as production increases and fall as production decreases – there is a direct relationship (Pirayoff, 2007). Fixed costs do not change with production or sales and they can include the price of rent or interest payments. It is important to note that in the long-run, all costs are variable because

This is simply the total costs subtracted from the total revenue. In a competitive market, firms are price takers “if the demand curve is horizontal at the market price” (Perloff, 2014, p.269). This means if the firm decides to increase the price by even a small amount, the demand will fall to zero. Consumers can simply go to another ‘competitor’ and buy a similar or the same product for a cheaper price. Therefore, it is not economically feasible to raise the price. The firm may lower the price, but it has no incentive to do so as the firm can sell as much of a product as they want to at the current market price. Consequently, if a firm is operating in a competitive market, then R(q)=pq (Perloff, 2014). This leads us to the profit maximising formula: p=MC(q), (Perloff, 2014). This leads us to the profit maximising formula: p=MC(q), as the cost to produce one more unit is the price the firms must take and sell their products

However, how does this look graphically?

If average costs are falling, marginal costs must be smaller, on the other hand if average costs are increasing then the marginal costs must be larger than the average costs. Therefore the marginal cost curve intersects the average cost curve from below, at its minimum (Lai et al., 2006), as seen above in figure 1.1.

Firms strive to maximize profits and so choose their output (q) optimally given the factor and output prices. The equilibrium must lie on the upward sloping part of the marginal cost curve. This is because when marginal costs are falling, it is better for the firm to expand (McEachern, 2008) and therefore an equilibrium not on the upward sloping part of the curve is not optimal and a higher profit can be achieved. However, there may not be an upward sloping part of the marginal cost curve above the average variable cost (note: average variable costs are equal to average costs in the long-run (Hubbard et al., 2014)). Therefore, the output of a competitive firm is determined by the upward sloping part of the marginal cost curve above the average cost curve in the