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Marginal Cost & Revenue: Understanding the Relationship between Them & Profit, Exercises of Cost Accounting

An introduction to marginal cost and revenue analysis, a key concept in economics. It explains how to calculate marginal cost and marginal revenue, and how they relate to profit. examples and visual aids to help illustrate the concepts.

Typology: Exercises

2021/2022

Uploaded on 09/12/2022

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2.5 MARGINAL COST AND REVENUE 1
2.5 Marginal Cost and Revenue
We start this section by looking at possible graphs of the cost and revenue
functions.
A cost function can be linear as shown in Figure 2.5.1(a) , or have the shape
shown in Figure 2.5.1(b). Note that in Figure 2.5.1(b), the graph is concave
down then concave up. This means that the cost function increases first at
a slow rate, then slows down, and finally increases at a faster rate.
Figure 2.5.1
Now, since R=pq, the graph of Ras a function of qis a straight line going
through the origin and with slope pwhen the price pis constant (See Figure
2.5.2(a)), or the graph shown in Figure 2.5.2(b).
Figure 2.5.2
pf3
pf4
pf5

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2.5 MARGINAL COST AND REVENUE 1

2.5 Marginal Cost and Revenue

We start this section by looking at possible graphs of the cost and revenue functions. A cost function can be linear as shown in Figure 2.5.1(a) , or have the shape shown in Figure 2.5.1(b). Note that in Figure 2.5.1(b), the graph is concave down then concave up. This means that the cost function increases first at a slow rate, then slows down, and finally increases at a faster rate.

Figure 2.5.

Now, since R = pq, the graph of R as a function of q is a straight line going through the origin and with slope p when the price p is constant (See Figure 2.5.2(a)), or the graph shown in Figure 2.5.2(b).

Figure 2.5.

Marginal Analysis Marginal analysis is an area of economics concerned with estimating the effect on quantities such as cost, revenue, and profit when the level of production is changed by a unit amount. For example, if C(q) is the cost of producing q units of a certain commodity, then the marginal cost, M C(q), is the additional cost of producing one more unit and is given by the difference M C(q) = C(q + 1) − C(q). Using the estimation

C′(q) ≈

C(q + 1) − C(q) (q + 1) − q

= C(q + 1) − C(q)

we find that

M C(q) ≈ C′(q)

and for this reason, we will compute the marginal cost by the derivative C′(q). Similarly, if R(q) is the revenue obtained from producing q units of a com- modity, then the marginal revenue, M R(q), is the additional revenue ob- tained from producing one more unit, and we compute M R(q) by the deriva- tive R′(q).

Example 2.5. Let C(q) represent the cost, R(q) the revenue, and P (q) the total profit, in dollars, of producing q units.

(a) If C′(50) = 75 and R′(50) = 84, approximately how much profit is earned by the 51stitem? (b) If C′(90) = 71 and R′(90) = 68, approximately how much profit is earned by the 91stitem?

Solution. (a) P ′(50) = R′(50) − C′(50) = 84 − 75 = 9. (b) P ′(90) = R′(90) − C′(90) = 68 − 71 = − 3. A loss by 3 dollars

Example 2.5. Cost and Revenue are given in Figure 2.5.3. Sketch the graphs of the marginal

We will see in Section 4.1, that the profit function attains its maximum for the level of production q for which P ′(q) = 0, i.e., M C(q) = M R(q). Geometrically, this occurs at q where the tangent line to the graph of C is parallel to the tangent line to the graph of R at q.

Example 2.5. A manufacturer estimates that when q units of a particular commodity are produced each month, the total cost (in dollars) will be

C(q) =

q^2 + 4q + 200

and all units are sold at a price p = 49 − q dollars per unit. Determine the price that corresponds to the maximum profit.

Solution. The revenue function is given by

R(q) = pq = 49q − q^2

and its derivative is M R(q) = 49 − 2 q. Setting this expression equal to the marginal cost to obtain 1 4

q + 4 = 49 − 2 q.

Solving for q we obtain q = 20 units. Thus, p = 49 − 20 = $

Example 2.5. Locate the quantity in Figure 2.5.5 where the profit function is maximum.

Figure 2.5.

2.5 MARGINAL COST AND REVENUE 5

Solution. The quantity q′^ for which profit is maximized is shown in Figure 2.5.6 where the tangent line to the graph of C at q′^ is parallel to the tangent line to the graph of R at q′

Figure 2.5.