Question

If the marginal revenue of a dozen tulips is $12 and marginal cost is $8, why wouldn’t this be an optimal level of production? Please also explain your answer with a figure.

Answer 1

Each firm has a general objective is to maximize its profit or minimize loss. The profit of a firm is given as

The first-order condition for profit maximization requires

Therefore, the firm acquired the highest profit where the marginal profit from each additional unit sold is zero or marginal revenue from each unit sold is exactly equal to the additional cost of producing it. If this does not hold then the firm is either producing too much or too little.

In this case, the MR is $12 and MC is $8, then at the current level of production, the firm is earning positive marginal profit. Then by increasing production, it can increase its profit. Hence the firm is producing too little. Hence, this is no optimal level of production.

In the figure, the TR and TC curve is drawn, the slope of these curves at any point gives the MR and MC respectively. The area between these curves is the profit of the firm. The firm is producing Q0 for which the MC is $8 and MR is $12. As the firm increases producing slope of TC rises and that of TR falls and the area between these curves widens. At Q* the distance between them is highest and MR=MC or both curve has the same slope. Then this is the optimal production which is higher than Q0. Therefore, Q0 is not the optimal production level.