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SENSITIVITY ANALYSIS

As we saw in Chapter 1, sensitivity analysis addresses the basic question: How

should the decision maker alter his or her course of action in light of changes in

economic conditions? Marginal analysis offers a powerful answer to this question:

For any change in economic conditions, we can trace the impact (if any) on the

firm’s marginal revenue or marginal cost. Once we have identified this impact, we

can appeal to the MR MC rule to determine the new, optimal decision.

Figure 2.9 illustrates the application of this rule for the microchip firm’s basic

problem. Consider part (a). As before, the firm’s decision variable, its output

quantity, is listed on the horizontal axis. In turn, levels of MR and MC are shown

on the vertical axis, and the respective curves have been graphed. How do we

explain the shapes of these curves? For MC, the answer is easy. The marginal

cost of producing an extra lot of chips is $38,000 regardless of the starting out-

put level. Thus, the MC line is horizontal, fixed at a level of $38,000. In turn,

the graph of the MR curve from Equation 2.8 is

We make the following observations about the MR equation and graph.

Starting from a zero sales quantity, the firm gets a great deal of extra revenue

from selling additional units (MR 170 at Q 0). As sales increase, the extra

revenue from additional units falls (although MR is still positive). Indeed, at a

quantity of 4.25 lots (see Figure 2.9) MR is zero, and for higher outputs MR is

negative; that is, selling extra units causes total revenue to fall. (Don’t be sur-

prised by this. Turn back to Figure 2.3 and see that revenue peaks, then falls.

When volume already is very large, selling extra units requires a price cut on

so many units that total revenue drops.)

In part (a) of Figure 2.9, the intersection of the MR and MC curves estab-

lishes the firm’s optimal production and sales quantity, Q 3.3 lots. At an out-

put less than 3.3 units, MR is greater than MC, so the firm could make

additional profit producing extra units. (Why? Because its extra revenue

exceeds its extra cost.) At an output above 3.3 units, MR is smaller than MC.

Here the firm can increase its profit by cutting back its production. (Why?

Because the firm’s cost saving exceeds the revenue it gives up.) Thus, profit is

maximized only at the quantity where MR MC.

Asking What if

The following examples trace the possible effects of changes in economic con-

ditions on the firm’s marginal revenue and marginal cost.

MR 170 40Q.

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