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Marginal profit is the profit that would be made by producing and selling one additional unit of a product or service. It is thus the difference between the marginal cost and marginal revenue of the extra unit. One economic theory states that a company should continue increasing production and sales until the marginal profit falls to zero.
The point of calculating marginal profit is that the costs and revenue of each unit are not always consistent. While the effects of this inconsistency do not make much difference to average costs and revenue, they can be significant for marginal costs and revenue. The marginal calculations are thus based on the specific level of production a company is on at the time of calculation.
Staff costs are an example of how marginal costs can vary immensely. If a workforce is not working to full capacity, the marginal labor cost will be zero: existing workers will be able to produce the extra unit during their shift. If a workforce is working precisely on capacity, the marginal labor cost could be very high: contract terms may mean that to produce one extra unit requires paying a worker a minimum of one hour's overtime even though the extra work only takes a few minutes. Of course, other factors such as electricity or raw materials might not vary as much.
Marginal revenue can also vary. In general, marginal revenue will fall as the quantity of sales increases. This is partly the fact that once a product price finds its natural level, it will take a price cut to get more customers to buy. Another factor is that increasing sales may require negotiating bulk discount deals with customers or wholesalers.
In most cases marginal revenue will start off negative, rise as sales increase, reach a peak, then decline and eventually become negative again. This is because for a company starting from scratch, the fixed costs of running a business will vastly outweigh the revenue from selling a small quantity of units. Increasing sales will mean the fixed costs play a smaller role in each additional unit sold. The peak and decline comes at the point when prices have to drop to attract additional buyers, reaching the eventual point where the marginal costs no longer outweigh marginal revenue.
One version of the economic theory of profit maximization is simply based on marginal profit. It states that the ideal level of production and sales is that where marginal profit has fallen to zero. Beyond this point additional production and sales will actually cost the company money. While this theory works in principle, there can be glitches such as the example of needing to pay overtime to produce a single extra unit. To avoid this, an economist may instead look for a point at which marginal revenue begins to be consistently at zero or even negative.
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