This is my own version of the marginal revenue and marginal cost diagram with the traditional version a complete waste of time. The traditional version has a series of lines many of which can never be drawn (such as the demand curve) with the ultimate point to show the price-quantity configuration for the sale of a single product. The conclusion is that if a firm wishes to maximise profitability on the sale of some good or service, it will price the product just exactly where a lower or higher price would lead to a lower return over cost. Fatuous and useless, with various bits of the real world left out, such as the actual ability to work out the effect on revenue of changing a price. Modern micro truly is as useless as modern macro.
The above diagram – discussed fully in my Free Market Economics – brings in a number of crucial factors:
- it is about whether some decision should be made rather than deciding on what price to charge
- it is about trying to make a decision in the face of a future that can never be foretold but is filled with endless uncertainties
- it recognises that there are costs that almost invariably must be borne before there is a return [Area A]
- costs continue even after revenues commence and only eventually, in a profitable venture, will revenues exceed costs [when B = A]
- the point of origin is the present moment when some decision must be made – all of the lines drawn are the expectations of the decision maker
- reality may turn out to be much different, with losses instead of a net positive return
- only when total revenue and total costs are equal – that is, when the expected addition to revenues is equal to the expected addition to costs (when MR=MC at the moment the decision is made) does the decision become profitable
This is the way a business, or anyone else for that matter, makes a decision: in the present with only one’s own conjectures as a guide.
I will lastly mention a very nice note I received the other day:
Just finished reading your book Free Market Economics and wanted to congratulate you.
I have read plenty of economic texts, but yours is the best by far and helped crystalize a number of things that have been swirling around in my mind.
It was truly appreciated. You can get a copy for yourself here. I didn’t make any of it up myself. It is just a distillation of classical theory, the economics of John Stuart Mill and his contemporaries.