What is ‘Marginal Profit’
Marginal profit is the profit earned by a firm or individual when one additional (marginal) unit is produced and sold. It is the difference between marginal cost and marginal product (also known as marginal revenue), and is often used to determine whether to expand or contract production, or to stop production altogether. Under mainstream economic theory, a company will maximize its overall profits when marginal cost equals marginal product, or when marginal profit is exactly zero.
Therefore, companies will tend to increase production until marginal cost equals marginal product, which is when marginal profit equals zero. This point will also tend to be the price level observed in the market, assuming there is competition among producers. If the marginal profit of a firm turns negative, its management may decide to scale back production, halt production temporarily, or abandon the business altogether if it appears that positive marginal profits will not return.
BREAKING DOWN ‘Marginal Profit’
Marginal profit is different from average profit, net profit, or other measures of profitability in that it looks at the money to be made on producing one additional unit. It accounts for scale of production because as a firm gets larger, its cost structure changes – and, depending on economies of scale, profitability can either increase or decrease as production ramps up.
Economies of scale refers to the situation where marginal profit increases as the scale of production ramps up. At a certain point, the marginal profit will become zero and then turn negative as scale increases beyond its intended capacity. At this point, the firm experiences dis-economies of scale.
How to Calculate Marginal Profit
Marginal cost (MCMC) is the cost to produce one additional unit and marginal product (MP) is the revenue earned to produce one additional unit.
Marginal Product (MP) – Marginal Cost (MCMC) = Marginal Profit (MP)
In modern microeconomics, firms in competition with each other will tend to produce units until marginal cost equals marginal product (MCMC=MP), leaving effectively zero marginal profit left for the producer. In fact, in perfect competition there is no room for marginal profits as competition will always push the selling price down to marginal cost, and a firm will operate until marginal product equals marginal cost; therefore, not only does MC=MP, but MC=MP=price.
If a firm cannot compete on cost and they operate at a marginal loss (negative marginal profit), they will eventually cease production. Profit maximization for a firm occurs, therefore, when it produces up to a level where marginal cost equals marginal product and the marginal profit is zero.
Variables to Consider (and What not to)
It is important to note that marginal profit is simply the profit earned to produce one additional item, and not the overall profitability of a firm. In other words, a firm should stop production at the level where producing one more unit begins to reduce overall profitability. Variables that contribute to marginal cost are factors such as labor, cost of supplies or raw materials, interest and taxes. Fixed costs, or sunk costs, should not be included in the calculation of marginal profit, since these one-time expenses do not change or alter the profitability of producing the very next unit. Psychologically, however, this tendency to include fixed costs is hard to overcome and many people fall victim to the sunk cost fallacy, leading to misguided and often costly management decisions.
Of course, in reality, many firms do operate with marginal profits maximized so that they always equal zero. This is because very few markets actually approach perfect competition due to technical frictions, regulatory and legal environments, and lags and asymmetries of information. Managers of a firm may not know in real time their marginal costs and revenues, which means they often must make decisions on production in hindsight and estimate the future. Additionally, many firms operate below their maximum capacity utilization in order to be able to ramp up production when demand spikes without interruption.