The principle that a firm should produce up to the point where the marginal revenue from the sale of an extra unit of output is equal to the marginal cost of producing it is known as the:
a. output-maximizing rule.
b. profit-maximizing rule.
c. shut-down rule.
d. break-even rule.
The correct answer and explanation is :
The correct answer is b. profit-maximizing rule.
Explanation:
The profit-maximizing rule is a fundamental concept in economics, specifically in microeconomics, related to the behavior of firms in a competitive market. According to this principle, firms maximize their profits by producing and selling a quantity of output where the marginal revenue (MR) from selling an additional unit of output equals the marginal cost (MC) of producing that unit. This is where the firm’s profit is at its highest, as the cost of producing one more unit exactly matches the revenue gained from selling that unit.
Marginal Revenue and Marginal Cost:
- Marginal Revenue (MR): This refers to the additional revenue a firm earns from selling one more unit of a good or service. For a competitive firm, the marginal revenue is constant and equal to the price of the good because each additional unit sold brings in the same amount of revenue.
- Marginal Cost (MC): This is the additional cost incurred by a firm to produce one more unit of a good or service. As production increases, the marginal cost can change depending on factors like input prices, production technology, and efficiency.
Why MR = MC?
At the point where MR = MC, the firm achieves the highest possible profit because:
- If MR > MC, it means that the firm is earning more revenue than it is spending to produce additional units, so it should produce more to increase profits.
- If MR < MC, it indicates that the firm is spending more to produce an additional unit than it is earning from it, so it should reduce production to avoid incurring losses.
Thus, the point where MR equals MC is the optimal level of production for maximizing profit. Producing beyond this point would result in diminishing returns and reduced profit.
In contrast:
- The output-maximizing rule doesn’t necessarily account for profit but focuses on quantity.
- The shut-down rule relates to a firm deciding whether to continue operating or temporarily shut down based on variable costs.
- The break-even rule refers to the point at which a firm’s total revenue equals its total costs, so the firm makes no profit but also incurs no loss.