9781118041581

256 Chapter 6 Cost Analysis

FIGURE 6.6

A Firm’s Optimal Output

Regardless of the

shape of its costs, a

firm maximizes its

profit by operating at

Q*, where marginal

revenue equals

marginal cost.

P°

P*

AC

Q° Q* Qmin Q′

Output

Dollars per Unit of Output

Demand′

Demand

MR′

MC

MR

AC

firm’s profit-maximizing output is Q* (where the MR and MC curves cross),

and its optimal price is P* (read off the demand curve). The firm’s economic

profit is measured by the area of the shaded rectangle in the figure. The rec-

tangle’s height represents the firm’s profit per unit (P* AC), and its base is

total output Q*. (Remember that the firm’s average cost includes a normal

return on its invested capital. Therefore, a positive economic profit means that

the firm is earning a greater-than-normal rate of return.) No alternative out-

put and price could generate a greater economic profit.

By now, the application of marginal revenue and marginal cost should be

very familiar. Nonetheless, it is worth pointing out two fallacies that occasion-

ally find their way into managerial discussions. The first fallacy states that the

firm always can increase its profit by exploiting economies of scale. But fully

exploiting these economies means producing at minimum efficient scale—the

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