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Marginal Revenue = Marginal Cost (MR = MC) Rule or Profit Maximization

Definition:

A firm under perfect competition faces an infinitely elastic demand curve or we can say for an individual firm, the price of the commodity is given in the market. The firm while making changes in the amounts of variable factor evaluates the extra cost incurred on producing extra unit MC (Marginal Cost).

It also examines the change in total receipts which results from the sale of extra unit of production MR (Marginal Revenue). So long as the additional revenue from the sale of an extra unit of product (MR) is greater than the additional cost (MC) which a firm has to incur on its production, it will be in the interest of the firm to increase production.

In economic terminology, we can say, a firm will go on expanding its output so long as the marginal revenue of any unit is greater than its marginal cost. As production increases, marginal cost begins to increase after a certain point. When both marginal revenue and marginal cost are equal, the firm is in equilibrium. The firm at this point is in equilibrium and either ensuring maximizing profit or minimizing loss.

This is shown with the help of a diagram below:

Diagram (Profit Maximization):

In the diagram (15.2) quantity of output is measured along OX axis and marginal cost and marginal revenue on OY axis. The marginal cost curve cuts the marginal revenue curve at two points K and T.

The competitive firm is in equilibrium, at both these points as marginal cost equals marginal revenue. The firm will not produce OM quantity of good because for OM output, the marginal cost is higher than marginal revenue. Marginal cost curve cuts the marginal revenue curve from above. The firm incurs loss equal to the black shaded area for producing 50 units (OM) of output.

As production is increased from 50 units to 350 units (from OM to OS) marginal cost decreases at early levels of output and then increases thereafter. The marginal cost curve cuts the marginal revenue curve from below at point T. The shaded portion between M to S level of output shows profit on production. When a firm produces OS quantity of output; it earns maximum profit. The point T where MR = MC is the point of maximum profit.

In case, the firm increases the level of output from OS, the additional output adds less to Its revenue than to its cost. The firm undergoes losses as is shown in the shaded area.

Summing up, profit maximization normally occurs at the rate of output at which marginal revenue equals marginal cost. This golden rule holds good for all market structures. As regards the absolute profits and losses of the firm, they depend upon the relation between average cost and average revenue of the firm.