INDIAN INSTITUTE OF TECHNOLOGY ROORKEE

BMN-505, Microeconomics
2021-22 Term 1

Chapter 2
Marginal Analysis
 Economics is about studying
• How we come to acquire the things that make up our
livelihood: Things like food, clothing, shelter, or free
time.
• How we interact with each other: Either as buyers and
sellers, employees or employers, citizens and public
officials, parents, children and other family members.
• How we interact with our natural environment: From
breathing, to extracting raw materials from the earth.
• How each of these changes over time.
 Definitions
• Economics is defined as the study of how individuals,
societies and economies use scarce resources to produce
valuable goods and services efficiently and distribute
them.

• The twin theme of economics

– Scarcity – limited availability of resources; all scarce
resources are economic resources
– Efficiency – a process is called an efficient process if it
produces the maximum possible output with the given
resources.
 Three fundamental concepts

• Opportunity cost

• Marginalism

• Efficient markets
A Simple model of the firm

A Microchip Manufacturer

Revenue

Cost

Profit

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Revenue

• The analysis of revenue rests on the most basic empirical

relationship in economics: the law of demand. This law
states:
– 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.
• The law operates at several levels: industry, individual
suppliers
• A price fall would increase demand through three factors
– Existing customers
– New customers
– Rivals’ customers
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The demand curve for microchips

The firm uses the

demand curve as the
basis for predicting the
revenue consequences of
alternative
output and pricing
policies.

The demand function can

be obtained as

Q = 8.5 – 0.05P
Or
P = 170 – 20 Q
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Two points need attention

• Ceteris paribus

• Deterministic demand curve

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Revenue from microchips
Revenue estimation task is to work with the mathematical
representation of the demand curve. Revenue = P  Q

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Revenue Function

• Given the inverse demand function, revenue function is

• R = 170 Q – 20 Q2

• If the demand function is Q = 360 – 4P

• Obtain the revenue function.

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Cost

• The firm estimates that to produce the microchip it

requires plant, equipment and labour which add up to 380
per chip.

• It also incurs a fixed cost of 100,000 per week.

• If one lot equals 100 units produced per week, then the
cost function is given as
C = 100 + 38 Q

• Q is the number of lots produced per week.

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The cost of microchips

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Profit

• Profit function is defined as

=R–C
= (170Q – 20Q2) – (100 + 38 Q)
= - 100 + 132 Q – 20 Q2

• Suppose the demand function is Q = 360 – 4P

• And the cost function is C = 400 + 32 Q

• Obtain the profit function

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Profit from microchips

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Marginal Analysis

•  Enumeration versus marginal analysis

• Marginal analysis looks at the change in profit that results

from making a small change in a decision variable.

• Marginal profit is the change in profit resulting from a small

increase in any managerial decision variable.

• Marginal profit =

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Marginal Profit

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A close-up view of profit
Maximum profit is attained at the output level at which marginal profit is zero.

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Marginal Profit

• Marginal profit (the slope of the corresponding profit graph) is

found by taking the derivative of the profit equation with respect to
Q.
• Given the profit equation
 = - 100 + 132 Q – 20 Q2
• Marginal profit is obtained as
M = 132 – 40 Q
• For various levels of Q, M can be calculated.
• Also the profit maximizing output can be obtained as Q = 3.3 lots.

• Obtain the profit maximizing output for the profit function

obtained earlier.

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Total profit
and marginal
profit

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Marginal revenue and marginal cost

Marginal Revenue

A Simplifying Fact: Given P = a – bQ,

Then MR = a – 2bQ.

Marginal Cost

Profit Maximization Revisited

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Marginal revenue and marginal cost

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Sensitivity analysis

Asking What If

Increased Overhead

Increased Material Costs

Increased Demand

Responding to Exchange Rate Changes

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Pricing Amazon’s Kindle

• In November 2007, Amazon introduced the Kindle, the first successful

reading device for electronic books. The price was a daunting $399. In
2009, the company dropped the Kindle’s price to $259 and in mid-2010
to $189. (Today, minimalist versions of the Kindle are priced under
$100.) Though Amazon is notoriously secretive about the Kindle’s sales,
revenues, and costs, financial analysts estimated annual sales to be
approximately 1 million units at the $259 price.
• At the time, there was some second guessing as to whether the price cut
to $189 made sense for the company—indeed whether the marginal
revenue from additional units sold exceeded Amazon’s marginal cost of
producing the Kindle. Amazon CEO Jeff Bezos appeared to be playing a
market-share strategy, predicated on establishing the Kindle as the
dominant platform for e-books and counting on maximizing profits
frome-book sales (rather than profits fromthe Kindle itself).

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Pricing Amazon’s Kindle
• Bezos reported that the price cut was successful in igniting Kindle sales,
claiming that the price cut to $189 had tripled the rate of sales (implying
annual sales of 3 million units at this lower price). Furthermore, it was
estimated that Amazon earned a contribution margin of $4 on each e-book
and that each Kindle sold generated the equivalent of 25 e-book sales over
the Kindle’s life. In other words, besides the marginal revenue Amazon
earned for each Kindle sold, it gained an additional MR (per Kindle) of
$100 due to new e-book sales.
• Suppose, Amazon’s inverse demand function is obtained as
• P = 294 – 35 Q
– In 2010, the marginal cost of producing the Kindle was estimated at $126 per unit.
Apply the MR = MC rule to find the output and price that maximize Kindle profits.
– Considering that each Kindle sold generates $100 in e- book profits, determine
Amazon’s optimal quantity and price with respect to the total profit generated by
Kindle and e-book sales. What is the implication for Amazon’s pricing strategy?

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Problem
Price Quantity
1. Obtain the demand and the inverse demand
340 0
function from the information given in the
table
328 60
2. Obtain the total revenue and the marginal
316 120 revenue functions
3. Assume that the cost function is given as
304 180 TC = 100 + 2Q2 -250 Q
4. Obtain the marginal cost function
292 240 5. Obtain the profit function
6. Derive the profit maximizing output, price
280 300 and profit.
268 360

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