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Handout for Chapter 2: Optimal Decisions Using Marginal Analysis

I. Calculus and Optimization Techniques: refer to the Appendix and the Analytical
Preliminaries.

II. A Simple Model of the Firm.


1. Revenue
1) The law of demand: All other factors held constant, the higher the unit price of
a good, the fewer the number of units demanded by consumers and,
consequently, sold by firms.
2) Downward sloping demand curve: P on the vertical axis and Q on the
horizontal axis.
3) Demand equation: mathematical representation of the demand curve; for any
price a firm charges, the demand equation predicts the resulting quantity of the
good that will be sold.
4) Inverse demand equation: For any quantity of the good that a firm plans to
sell, the inverse demand equation predicts the price needed to sell exactly this
quantity.
5) Revenue function: R=P·Q, where P comes from the inverse demand equation.
2. Cost: C=FC+VC.
3. Profit: π = R – C.

III. Profit Maximization: Marginal Profit


1. Marginal profit: the change in profit resulting from a small change in any
managerial decision variable, e.g., output.
2. Mπ = (change in profit)/(change in output)=∆ π/∆Q=d π/dQ.
3. If Mπ=$12 thousand at Q=3 lots, what does it mean?
4. Graphically, marginal profit at a particular Q is given by the slope of the tangent
line touching the profit curve at that output level.
1) Upward sloping tangent: Mπ>0.
2) Downward sloping tangent: Mπ<0.
3) Horizontal tangent: Mπ=0.
5. Maximum profit is attained at Q* where Mπ=0.
1) Marginal analysis: Expand an activity if and only if the extra benefit exceeds
the extra cost.
2) If Mπ>0, Q<Q*, the firm should increase output to increase profit, until
Mπ=0.
3) If Mπ<0, Q>Q*, the firm should reduce output to increase profit.
6. After finding out Q*, we can use inverse demand equation to find out P*. Then
we can use the equations to find out R, C and π resulting from the firm’s optimal
output and price decision.

IV. Marginal Revenue and Marginal Cost


1. Marginal revenue.
1) MR = (change in revenue)/ (change in output) =∆ R/∆Q=d R/dQ.

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2) Graphically, marginal revenue at a particular Q is given by the slope of the
tangent line touching the revenue curve at that output level.
3) For a linear demand curve with an inverse demand equation of the form
P=a – bQ, the resulting marginal revenue is MR=a – 2bQ.
4) Revenue is maximized at an output where MR=0: if MR>0, increase output to
increase revenue until MR=0.
2. Marginal cost.
1) MC = (change in cost)/ (change in output) =∆ C/∆Q=d C/dQ.
2) Graphically, marginal cost at a particular Q is given by the slope of the tangent
line touching the cost curve at that output level.
3. Profit maximization revisited.
1) Mπ=MR – MC.
2) Q* occurs at Mπ=0, or MR=MC.
a. If MR>MC, Mπ>0, Q<Q*, the firm should increase output to increase
profit, until MR=MC and Mπ=0.
b. If MR<MC, Mπ<0, Q>Q*, the firm should reduce output to increase
profit.

V. How Should the Firm Responds if


1. Fix cost changes.
2. Marginal cost changes.
3. Demand changes.

Practice Problems: 4, 6, 7a, 7c, 12 in the textbook and the mini-case on the next page.

2
Apple Computer in the Mid 90s

Between 1991 and 1994, Apple Computer engaged in a holding action in the desktop
market dominated by PCs using Intel chips and running Microsoft’s operating system.1
In 1994, Apple’s flagship model, the Power Mac, sold roughly 10,000 units per month at
an average price of $3,000 per unit. At the time, Apple claimed about a 9% market share
of the desktop market (down from greater than 15% in the 1980s).

By the end of 1995, Apple had witnessed a dramatic shift in the competitive environment.
In the preceding 18 months, Intel had cut the prices of its top-performing Pentium chip by
some 40%. Consequently, Apple’s two largest competitors, Compaq and IBM, reduced
average PC prices by 15%. Mail-order retailer Dell continued to gain market share via
aggressive pricing. At the same time, Microsoft introduced Windows 95, finally offering
the PC world the look and feel of the Mac interface. Many software developers began
producing applications only for the Windows operating system or delaying development
of Macintosh applications until months after Windows versions had been shipped.
Overall, fewer users were switching from PCs to Macs.

Apple’s top managers grappled with the appropriate pricing response to these competitive
events. Driven by the speedy new PowerPC chip, the Power Mac offered capabilities and
a user-interface that compared favorably to those of PCs. Analysts expected that Apple
could stay competitive by matching its rivals’ price cuts. However, John Sculley, Apple’s
CEO, was adamant about retaining a 50% gross profit margin and maintaining premium
prices. He was confident that Apple would remain strong in key market segments – the
home PC market, the education market, and desktop publishing.

Questions.

1. In 1994, the marginal cost of producing the Power Mac was about $1,500 per unit, and
a rough estimate of the monthly demand curve was: P = 4,500 - .15Q. At the time, was
Apple’s output and pricing policy optimal?
2. By the end of 1995, some analysts estimated that the Power Mac’s user value (relative
to rival PCs) had fallen by as much as $600 per unit. Apple’s new demand curve at end-
of-year 1995 was given by: P = 3,900 - .15Q. How much would sales fall if Apple held to
its 1994 price? Assuming a marginal cost reduction to $1,350 per unit, what output and
price policy should Apple now adopt?

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This account is based on J. Carlton, “Apple’s Choice: Preserve Profits or Cut Prices,”
The Wall Street Journal, February 22, 1996, p. B1.