Practical Applications Of Marginal Analysis

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The practical usefulness of marginal analysis is easily demonstrated with simple examples that show how managers actually use the technique. Common applications are to maximize profits or revenue, or to identify the average-cost minimizing level of output.

MANAGERIAL APPLICATION 2.3

How Entrepreneurs Shape the Economy

Firms often are started by a single individual with no more than an idea for a better product or service—the entrepreneur. Taken from the Old French word entreprendre, meaning "to undertake," the term entrepreneur refers to one who organizes, operates, and assumes the risk of a business venture. Until recently, there was little academic or public policy interest in this key function. The entrepreneur's skill was simply considered part of the labor input in production. Now, both academicians and practitioners are beginning to better understand the critical role of the entrepreneur, partly because entrepre-neurship has become a formal field of study at many leading business schools.

As a catalyst, the entrepreneur brings economic resources together in the risky attempt to meet customer needs and desires. This process often leads to failure— in fact, the odds against success are long. Seldom do more than one in ten start-up businesses enjoy even minimal economic success. Even those select few that see their product or service reach a national market find stable long-term success elusive. Once established, they in turn become targets for future entrepreneurs. As entrepreneurs create new opportunities, they destroy the old way of doing things. Entrepreneurship plays an important role in what economist Joseph Schumpeter called the "creative destruction of capitalism"—the process of replacing the old with the new and the inefficient with the efficient.

Given the long odds against success, one might wonder why so many willingly embark on ventures (adventures?) that appear doomed to fail. One reason is that one-in-a-million chance of developing "the" truly revolutionary product or service that will fundamentally change how people live, work, play, or shop. Even though the opportunity for wealth is surely an important motivation, the impact and recognition that come with creating a truly unique good or service often are equally important to entrepreneurs. Many simply want to "make a difference." Whatever the motivation, entrepreneurs play a key role in our economy.

See: Gordon G. Chang, "Eager Entrepreneurs, Far from Silicon Valley," The Wall Street Journal Online, March 12, 2002 (http://online.wsj.com).

Profit Maximization

The most common use of marginal analysis is to find the profit-maximizing activity level. To show how this is done, consider the case of the Storrs Manufacturing Company, located in West Hartford, Connecticut. The company has developed and test-marketed the "Golden Bear Golf Cart," a new and highly energy-efficient golf cart. The product is unique, and preliminary indications are that Storrs can obtain a substantial share of the national market if it acts quickly to expand production from its current level of 400 units per month. Data from independent marketing consultants retained by Storrs indicate the following monthly demand, total revenue, and marginal revenue relations:

where P is price and Q is output.

In addition, Storrs' accounting department has estimated monthly total cost and marginal cost relations of

TC = $1,012,500 + $1,500Q + $1.25Q2 (Total cost) MC = ATC/AQ = $1,500 + $2.5Q (Marginal cost)

These relations can be used to determine the optimal activity level for the firm. Profit will be maximized where MR = MC. This suggests an activity level of 600 units, because

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