C530 Economics for Managers

Handout 2
Marginal Analysis

Professor Rauh

Fall 2021

1
Quote

A self-fulfilling prophecy
Of endless possibility.
You roll in reams across the street
In algebra, in algebra.
Thom Yorke

2
Outline of the Course

1 Foundation case.
2 Tools: marginal analysis, complementarity, and global analysis.
3 Basics: production and cost.
4 Markets: perfect competition, monopoly, pricing, and
oligopoly.
5 Game theory.
6 Limiting or escaping the competition.

3
Introduction

4
Introduction

There are two aspects to marginal analysis:

• Change how you think: learn to think like an economist.

• A tool for solving problems.

The first is perspective and the second is mathematical.

5
Monopoly Example

6
Monopoly Example

We consider a simple hypothetical to explain the main concepts.

The following is historical data for a monopolist (a firm with no

competition).

The first two columns are historical data on demand. The first
column is quantity sold (in thousands of units) at the
corresponding price in the second column.

7
Historical Data

Total Production Cost

Q p C
20 80 200
25 75 225
30 70 250
35 65 275
40 60 300
45 55 325
50 50 350
55 45 375
60 40 400

8
Data Availability

Most companies possess this information but are extremely

reluctant to share it with outsiders for obvious reasons.

Examples: Amazon, Kroger, Ford, Global Gifts.

Financial statements generally do not contain this kind of

information.

9
Demand

Price

100

80

60

40

20

Quantity
20 40 60 80 100

10
Law of Demand

The diagram is obtained by fitting a smooth curve to the historical

data.

The Law of Demand states that consumers buy less as the price
rises. Violations are rare.

In case competitions, judges are going to be skeptical if you claim

that you will sell a lot at a high price or that a price increase will
not reduce sales very much.

11
Cost

Production involves labor costs, raw materials costs, capital and

equipment costs, etc.

The third column expresses these costs C in thousands of dollars.

We will study costs in more detail in Handouts 6 and 7.

12
Cost

Cost

600

500

400

300

200

Output
20 40 60 80 100

13
Questions

How much output Q should the firm produce?

What price p should the company charge?

14
Revenue and Profit

Revenue is price times quantity

R = pQ (1)

in thousands of dollars. Profit is revenue minus cost

Π = R − C = pQ − C (2)

in thousands of dollars.

15
Historical Data

Q p R C Π
20 80 1,600 200 1,400
25 75 1,875 225 1,650
30 70 2,100 250 1,850
35 65 2,275 275 2,000
40 60 2,400 300 2,100
45 55 2,475 325 2,150
50 50 2,500 350 2,150
55 45 2,475 375 2,100
60 40 2,400 400 2,000

16
Revenue

Revenue

2500

2000

1500

1000

500

Output
20 40 60 80 100

17
Profit

Profit

2000

1500

1000

500

Output
20 40 60 80 100

-500

18
Revenue and Profit Eventually Decline

Eventually, revenue must decline because of the Law of Demand:

the firm has to lower its price to sell more.

We consider this phenomenon again when we study the concept of

elasticity.

Eventually, profit must decline because of the Law of Demand and

because of increasing costs.

19
Solution?

Produce Q = 45, 000 at the price p = 55 or Q = 50, 000 at

p = 50.

Profit is $2,150,000 for both options.

This is the optimal solution based on what we have done in the

past.

How do we know this is really the solution?

20
Marginal Revenue and Marginal Cost

21
Marginal Revenue

Marginal revenue is the change in revenue divided by the change in

output
∆R
MR = . (3)
∆Q
If we increase output from Q = 25 to Q = 30,
∆R 2, 100 − 1, 875 225
MR = = = = 45. (4)
∆Q 5 5
Revenue increased by 225, which is an increase of 45 per unit.

22
Marginal Revenue and Marginal Cost

Q p R C Π MR MC
20 80 1,600 200 1,400 - -
25 75 1,875 225 1,650 55 5
30 70 2,100 250 1,850 45 5
35 65 2,275 275 2,000 35 5
40 60 2,400 300 2,100 25 5
45 55 2,475 325 2,150 15 5
50 50 2,500 350 2,150 5 5
55 45 2,475 375 2,100 -5 5
60 40 2,400 400 2,000 -15 5

23
Marginal Revenue

One unit = 1,000 units of output.

This is an average. We do not know the effect of increasing output

from 25 to 26.

Marginal revenue refers to the change from the previous row to the
current one, not the current row to the next one.

24
When You Divide, It Becomes Per-Unit

If your car uses 6 gallons of gas to travel 180 miles then

Distance Travelled ∆Position 180

= = = 30. (5)
Fuel Used ∆Fuel 6
Thirty miles per gallon. Again this is an average.

25
Marginal Cost

Marginal cost is
∆C
MC = . (6)
∆Q
If we increase output from Q = 25 to Q = 30,
∆C 250 − 225 25
MC = = = = 5. (7)
∆Q 5 5
Cost increased by 25, which is an increase of 5 per unit.

Marginal cost is the change in cost when the firm changes output
by one unit.

26
Marginal Analysis

If MR > MC the firm should increase output.

The increase in revenue is greater than the increase in cost, so

profit increases.

If MR = MC then the increase in revenue is exactly the same as

the increase in cost, so profit stays the same.

The firm can either increase output or stay where it is because

there is a tie.

27
Marginal Analysis

If MR < MC the firm should reduce output.

If MR = 5 and MC = 10 and the firm reduces output by one unit

then revenue will decrease by 5 but cost will decrease by 10, so
profit increases.

If marginal revenue is negative, as in the table, then revenue will

actually increase.

28
Analytics

So far all we have done is reproduce the previous answer in a

different way.

We need to move beyond the historical data to discover something

about the processes generating the data.

This is the role of business analytics, econometrics, and other

quantitative techniques.

29
Analytics

The firm can estimate demand and cost functions with historical
data using econometric techniques.

Alternatively, one can employ a consulting firm or use a standard

software package like Azure from Microsoft.

[Link]
us/solutions/architecture/interactive-price-analytics/

A much better way is to run experiments like Amazon and some

other companies do.

30
Pricing Algorithms

Prices are often set using algorithms which employ various

formulas.

For an amusing discussion of how a biology textbook came to be

priced at $23,698,655.93 see

[Link]

31
Demand and Cost

The data were generated by the following demand and cost

functions

p = 100 − Q (8)
C = 5Q + 100. (9)

These are the exact processes generating the historical data.

For example, we can see what will happen to Q for values of p not
in the table.

In reality, one obtains estimates that contain errors.

32
Indian Engineers

How can you have Q on one side measured in thousands of units

of output and p on the other side measured in dollars?

Normally, the slope coefficient m in the equation

y = mx + b (10)

converts the x variable into the units of the y variable.

For simplicity, here m = −1.

33
Price or Quantity but not Both

The monopolist cannot set both price and quantity.

If the monopolist produces Q = 80 and charges p = 50 then he

will sell
Q = 100 − p = 50. (11)

The monopolist does not care which one he sets and we will think
in terms of quantity Q.

34
Cost

The cost function has two components:

i A fixed cost F = 100 which includes various overhead costs.

ii Variable cost VC = 5Q which indicates that it costs $5 to
produce each unit.

35
Revenue and Profit

Revenue (or sales) and profit are given by

p = 100 − Q (12)
2
R = pQ = (100 − Q)Q = 100Q − Q (13)
2
Π = R − C = (100Q − Q ) − (5Q + 100) (14)
2
= 95Q − Q − 100. (15)

36
Now What?

We could start plugging in various values of Q to find the Q that

maximizes profit.

We will employ a much more efficient procedure based on marginal

analysis.

But first we need to review some basic math.

37
Math Review

38
Quote

In mathematics you don’t understand things.

You just get used to them.

John von Neumann

39
Continuous Variables

A continuous variable is one that can take any numerical value,

including fractional units.

We now think of all variables as continuous variables even when it

is not literally true.

40
Tangent

Consider the function f (x) = x 2 graphed in blue below.

The expression f (x) means that f is a function of the variable x.

A line is tangent to a curve at a particular point if the line touches

but does not cross the curve at that point.

The gold line is tangent to the curve f (x) = x 2 at the point x = 2.

41
Tangent

25

20

15

10

x
1 2 3 4 5

-5

42
Definition of Slope

The slope of a curve at a particular point is defined to be the slope

of the line tangent to the curve at that point.

The slope tells us how the function f changes due to an

infinitesimal change in x.

If the slope is 4 then the value of the function f will increase by 4

if we increase x by one infinitesimal unit.

It will decrease by 4 if we reduce x by one infinitesimal unit.

43
Slope of the Revenue Function

The slope of the revenue function

R = pQ = (100 − Q)Q = 100Q − Q 2 (16)

tells us the change in revenue that occurs when the firm increases
production by one infinitesimal unit.

Economists also call this marginal revenue.

44
A Trick We Will Use a Thousand Times

When demand is linear

y = mx + b (17)
p = 100 − Q (18)

the slope of the revenue function is

MR = 100 − 2Q. (19)

We take the demand curve and double the slope.

45
Two Marginal Revenues

i The change in revenue when we change production by one

unit
∆R
MR = . (20)
∆Q
ii The slope of the revenue function, which tells us how revenue
changes when output changes by one infinitesimal unit.

Fact from calculus: for small changes, the two marginal revenues
are approximately the same.

46
In the Weeds for a Minute

Consider a unit increase in output from Q = 2 to Q = 2.001. The

change in revenue is

R = pQ = (100 − Q)Q = 100Q − Q 2 (21)

∆R = 196.095999 − 196 = 0.095999 (22)
∆Q = 2.001 − 2 = 0.001 (23)

and marginal revenue is

∆R 0.095999
= = 95.999. (24)
∆Q 0.001
Revenue will increase by about $96 if the firm produces one more
unit.

47
In the Weeds for a Minute

If we increase output by one infinitesimal unit, starting from Q = 2,

MR = 100 − 2Q = 100 − 2(2) = 96 (25)

∆R 0.095999
= = 95.999. (26)
∆Q 0.001
The slope is calculated by plugging the starting point Q = 2 into
the marginal revenue function.

The second marginal revenue is calculated by increasing output

from the base point Q = 2 to Q = 2.001.

48
Marginal Cost

The cost function is a straight line

C = 5Q + 100 (27)
y = mx + b (28)

with slope 5. In this case, marginal cost

∆C
MC = (29)
∆Q
and the slope of the cost function are always exactly the same.

This holds for straight lines but not for curves like the revenue
function.

49
Marginal Analysis

We now plot demand, marginal revenue, and marginal cost

p = 100 − Q (30)
MR = 100 − 2Q (31)
C = 5Q + 100 (32)
MC = 5. (33)

50
Demand (Blue), Marginal Revenue (Gold), and Marginal
Cost (Green)

Price

100

80

60

40

20

Output
20 40 60 80 100
-20

51
Marginal Revenue is Less than Price

Except for the first unit, marginal revenue is less than price: the
marginal revenue curve lies below the demand curve.

For example, when Q = 25

p = 100 − Q = 100 − 25 = 75 (34)

MR = 100 − 2Q = 100 − 2(25) = 50. (35)

If the firm sells another unit, shouldn’t revenue increase by the

price of that unit?

52
Marginal Revenue is Less than Price

No. If the firm increases Q from Q = 25 to Q = 26 then

p = 100 − Q = 100 − 26 = 74 (36)

∆R = (74)(26) − (75)(25) = 1, 924 − 1, 875 = 49. (37)

When the firm increases production from Q = 25 to Q = 26, the

firm makes $74 on each of the new sales.

53
Marginal Revenue is Less than Price

But the consumers who previously paid $75 each when Q = 25

now pay $74 each when Q = 26, so

∆R = new sales − loss on old sales = 74 − 25 = 49. (38)

Marginal revenue is less than price because to make the new sales,
the firm has to lower its price, not just for the new customers, but
also for existing ones.

Marginal revenue is negative when the loss on old sales exceeds the
gain from new sales.

54
Key Point

Output levels where MR > MC are not optimal because an

increase in output would increase profit.

Output levels where MR < MC are not optimal because a

reduction in output would increase profit.

The output level that maximizes profit is where MR = MC .

55
Marginal Revenue = Marginal Cost

The output level that maximizes profit is Q = 47, 500.

p = 100 − Q (39)
MR = 100 − 2Q (40)
C = 5Q + 100 (41)
MR = MC (42)
100 − 2Q = 5 (43)
95 = 2Q (44)
Q = 47.5. (45)

56
Price, Profit Margin, and Profit

We obtain the price from the demand curve

p = 100 − Q = 100 − 47.5 = 52.5. (46)

The profit margin is p − 5 = 47.5 and profit is

Π = R − C = pQ − (5Q + 100) (47)

= pQ − 5Q − 100 = (p − 5)Q − 100 (48)
= (47.5)(47.5) − 100 = 2, 156.25 (49)

or $2,156,250.

Profit Margin = Price - Marginal Cost

57
Things People Say

MBA: if MR = MC then how does the firm make money?

Me: MR = MC at Q = 47.5 but MR > MC for all previous units.

58
Marginal Analysis

This is the correct answer which is different from our previous

answer based on the historical data.

i We looked beyond the historical data to think about the

demand and cost structures that generated the data.
ii We used marginal analysis on the results.

59
Discussion

i Do firms maximize profit? Although firms are not exclusively

motivated by profit, it is usually the most important motive.
ii What if your boss does not know what marginal revenue
means?

60
Medical Industry

Under Medicare rules, long-term acute-care hospitals like Kindred’s

typically receive smaller payments for what is considered a short
stay, until a patient hits a threshold. After that threshold, payment
jumps to a lump sum meant to cover the full course of long-term
treatment.

[Link]
times-1424230201

61
Medical Industry

62
Medical Industry

This is evidence of purposeful behavior with an objective that

mixes the profit motive with patient care (or reputation) because
some patients were retained after 20 days.

63
Pool Players

We can model this person using the laws of physics.

Only an approximation because he misses some shots.

64
Marginal Analysis

The standard pricing formula

 
E
p= MC (50)
1+E

which Azure uses is just MR = MC written in a different way.

Different companies have different approaches to pricing but the

concepts MR and MC should be and are the starting point.

65
Marginal Profit

Marginal profit is the slope of the profit function

Π = 95Q − Q 2 − 100. (51)

It is the change in profit due to an infinitesimal change in output.

66
Marginal Profit = Marginal Revenue - Marginal Cost

Suppose that MR = 10 and MC = 5.

A small increase in output will increase revenue by 10 and increase

cost by 5.

Π=R −C (52)
MΠ = MR − MC = 10 − 5 = 5. (53)

Profit will therefore increase by 5.

67
Marginal Profit = 0

The output level that maximizes profit occurs where marginal

profit (the slope) is zero.

Profit

2000

1500

1000

500

Output
20 40 60 80 100

-500

68
Marginal Profit

If MΠ > 0 a small increase in output will increase profit. The firm

should therefore keep increasing output as long as MΠ > 0.

If MΠ < 0 a small decrease in output will increase profit. The firm

should therefore keep reducing output as long as MΠ < 0.

The optimal level of output is where MΠ = 0.

69
Marginal Profit

Since
MΠ = MR − MC (54)
the rule MΠ = 0 is equivalent to MR = MC .

70
General Marginal Analysis

71
General Framework

Let x be a choice variable and B(x) and C (x) the associated

benefits and costs.

The notation B(x) and C (x) means that the benefit and cost are
functions of x.

The payoff of the decision-maker is the net benefit, the difference

between the benefits and costs N = B − C .

The decision-maker wants to choose x to maximize N.

72
Previous Example: the Monopolist

• The choice variable x is output Q.

• The benefit B is revenue R = pQ.
• The cost is the production cost.
• The net benefit N = B − C is profit Π = R − C .

73
Another Example: Studying for C530

• The choice variable x is time spent studying for this course.

• The benefit B is the grade you expect to get, given the time x
you spent studying.
• The cost is the opportunity cost of your time.
• The payoff is the net benefit N = B − C , measured in “utils”
or whatever.

The cost of studying C530 is not a dollar cost but rather the value
of the next best alternative use of your time: studying accounting,
sleeping, socializing, etc.

74
Cost and Opportunity Cost

There are three options available: A (the best), B (second best),

and C (third best).

The opportunity cost of a choice is the value of the best choice

forgone.

The opportunity cost of A is B and the opportunity cost of B and

C is A.

75
Opportunity Cost

The cost of an in-residence MBA consists of the direct costs

(tuition, etc.) plus the opportunity cost of forgone wages.

76
Diagram

77
Diagram

• The PDF might be clearer.

• The top panel is given information. We deduce the second
and third panels from the first one.
• The benefit and cost curves have reasonable shapes.

78
Net Benefit

We first derive the second panel from the first.

The net benefit N = B − C is the vertical distance between B and

C in the top panel.

The net benefit N is zero when B and C cross, which happens at

two distinct points.

N increases as the vertical distance between B and C grows, then

peaks, and then declines as the vertical distance falls.

79
Marginal Benefit

The marginal benefit MB is the slope of B, which indicates how B

changes due to an infinitesimal change in x.

E.g., if MB = 5 then if x increases by one infinitesimal unit then B

will increase by 5.

In the top diagram, the slope of B is positive but diminishing, then

zero, and then increasingly negative.

In the bottom diagram, the marginal benefit declines.

Note that the point x where MB = 0 is the same point where B is

maximized.

80
Benefit

81
Marginal Cost

The marginal cost MC is the slope of C , which indicates how C

changes due to an infinitesimal change in x.

E.g., if MC = 6 then if x decreases by one infinitesimal unit then

C will decrease by 6.

In the top diagram, the slope of C is positive and getting more

positive.

In the bottom diagram, MC is increasing.

82
Marginal Net Benefit

The marginal net benefit is the slope of N, which indicates how N

changes due to an infinitesimal change in x.

If MB = 10 and MC = 6 then if x increases by one infinitesimal

unit then B will increase by 10, C will increase by 6, and N will
increase by 4.

This shows that MNB = MB − MC .

In the monopoly example, MNB was marginal profit.

83
The Optimal Choice

The optimal choice is the value of x that maximizes N.

In the top diagram, the optimal x maximizes the vertical distance

between B and C
N = B − C. (55)
In the middle diagram, the same x occurs where MNB = 0.

In the bottom diagram, the optimal x is where MB = MC .

84
The Same Logic as Before

If MNB > 0 or MB > MC you should increase x.

The benefit will increase more than the cost increases, so the net
benefit will increase.

If MNB < 0 or MB < MC you should decrease x.

Cost will decrease more than the benefit decreases, so the net
benefit will increase.

85
Marginal Benefit and Marginal Cost

86
Fixed Costs

A fixed cost is a cost that does not change when the choice
variable x changes.

Debt payments are a fixed cost with respect to the production

level.

Whether or not a cost is fixed depends on the choice variable.

Debt payments are not fixed with respect to the decision to declare
bankruptcy.

87
Fixed Costs

The optimal value of a choice variable x depends on its marginal

benefits and marginal costs.

In other words, how the benefits and costs change as x changes.

Since fixed costs are fixed, they do not change as x changes.

88
Fixed Costs

When a decision-maker chooses x, she should ignore fixed costs.

You should not think about your rent for retail space when pricing
your products.

89
Multivariate Marginal Analysis

90
Multivariate Marginal Analysis

Suppose there are two choice variables, x and y .

The benefit B(x, y ) and the cost C (x, y ) depend on the values of
both x and y .

Example: a monopolist sells two products.

The net benefit is the benefit minus the cost

N(x, y ) = B(x, y ) − C (x, y ). (56)

91
Marginal Costs

The marginal cost of x, MCx , is the change in the cost C when we

change x keeping y fixed at its current value.

Example: the increase in costs when we increase production of one

product keeping the production level of the other product fixed.

The marginal cost of y , MCy , is the change in the cost C when we

change y keeping x fixed at its current value.

92
Example

Suppose we increase x from x = 0 to x = 1 while y remains fixed

at y = 0.

x y C = x 2 + xy + y 2
0 0 0
1 0 1

∆C 1−0
MCx = = = 1. (57)
∆x 1−0

93
Example

The marginal cost of x depends on the value of y .

x y C = x 2 + xy + y 2
0 1 1
1 1 3

∆C 3−1
MCx = = = 2. (58)
∆x 1−0

94
Marginal Benefits

The marginal benefit of x, MBx , is the change in the benefit B

when we change x keeping y fixed at its current value.

Example: the change in revenue when we increase production of

one product keeping the production level of the other product fixed.

The marginal benefit of y , MBy , is the change in the benefit B

when we change y keeping x fixed at its current value.

95
Marginal Net Benefit

The marginal net benefit of x, MNBx , is the change in the net

benefit N when we change x keeping y fixed at its current value.

Example: the change in profit when we increase production of one

product keeping the production level of the other product fixed.

The marginal net benefit of y , MNBy , is the change in the net

benefit N when we change y keeping x fixed at its current value.

96
Marginal Net Benefits Should Be Zero

The decision-maker wants to choose x and y to maximize the net

benefit N.

The net benefit is maximized when

MNBx = 0 (59)
MNBy = 0. (60)

97
Marginal Net Benefits Should Be Zero

If MNBx > 0 the net benefit is not maximized because an increase

in x with the current value of y held fixed will increase the net
benefit.

If MNBx < 0 the net benefit is not maximized because a decrease

in x with the current value of y held fixed will increase the net
benefit.

Similarly for MNBy .

98
Marginal Benefits Should Equal Marginal Costs

Alternatively, the net benefit is maximized when

MBx = MCx (61)

MBy = MCy . (62)

99
Marginal Benefits Should Equal Marginal Costs

If MBx > MCx the net benefit is not maximized at the current
values of x and y because an increase in x with y held fixed at its
current would increase the net benefit.

If MBx < MCx the net benefit is not maximized because a

decrease in x with y held fixed at its current value would increase
the net benefit.

Similarly for MBy and MCy .

100
Old Man Wisdom of the Day

Someone suggests changing some elements of the organization’s

strategy, such as prices.

Ask them the Marginal Analysis Question: What changed?

101
Appendix

We use calculus to show that the “double the slope” rule for
marginal revenue is correct. For a linear demand curve,

p = a − bQ (63)
R = pQ = (a − bQ)Q = aQ − bQ 2 (64)
dR
MR = = a − 2bQ. (65)
dQ

102