Market and Command Economies

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Economics is a science that analyzes what, how, and for whom society produces. The central economic problem is to reconcile the conflict between people's unlimited demands with society's ability to produce goods and services.

In industrial Western countries markets are to allocate resources. The market is the process by which production and consumption are coordinated through prices.

In a command economy, a central planning office makes decisions on what, how, and for whom to produce. Economy cannot rely entirely on command, but there was extensive planning in many Soviet bloc countries.

 A free market economy has no government intervention. Resources are allocated entirely through markets.

Modern economies in the West are mixed and rely mainly on the market but with a large dose of government intervention. The optimal level of government intervention remains a problem which is of interest to economists.

The degree of government restrictions differs greatly between countries that have command economies and countries that have free market economies. In the former, resources are allocated by central government planning. In the latter, there is not any government regulation of the consumption, production, and exchange of goods. Between the two main types lies the mixed economy where market and government are both of importance.

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1. Many economists specialise in a particular branch of the subject. For example, there are labour economists, energy economists, monetary economists, and international economists. What distinguishes these economists is the segment of economic life in which they are interested. Labour economics deals with problems of the labour market as viewed by firms, workers, and society as a whole. Urban economics deals with city problems: land use, transport, congestion and housing. However, we need not classify branches of economics according to the area of economic life in which we ask the standard questions: what, how and for whom. We can also classify branches of economics according to the approach or methodology that is used. The very broad division of approaches into microeconomic and macroeconomic cuts across the large number of subject groupings cited above.

2. Microeconomic analysis offers a detailed treatment of individual decisions about particular commodities. Microeconomists tend to offer a detailed treatment of one aspect of economic behaviour, but ignore interactions with the rest of the economy in order to preserve the simplicity of the analysis. A microeconomic analysis of miners' wages would emphasise the characteristics of miners and the ability of mine owners pay. It would largely neglect the chain of indirect effects to which a rise in miners’ wages might give rise. For example, car workers might use the precedent the miners' pay increase to secure higher wages in the car industry, thus being able to afford larger houses, which burned more coal in heating systems. When microeconomic analysis ignores such indirectly induced effects it is said to be partial analysis.

3. Macroeconomics emphasizes the interactions in the economy as a whole. For example, macroeconomists typically do not worry about the breakdown of consumer goods into cars, bicycles, televisions, and calculators. They prefer to treat them all as a single bundle called "consumer goods" because they are more interested in studying the interaction between

3

Demand is the quantity of a good that buyers wish to buy at each price. Other things equal, at low prices the demanded quantity is higher.

Supply is the quantity of a good that sellers wish to sell at each price. Oth­er things equal, when prices are high, the supplied quantity is high as well.

The market is in equilibrium when the price regulates the quantity supplied by producers and the quantity demanded by consumers. When prices are not so high as the equilibrium price, there is excess demand (shortage) raising the price. At prices above the equilibrium price, there is excess supply (surplus) reducing the price.

There are some factors influencing demand for a good, such as the prices of other goods, consumer incomes and some others.

An increase in the price of a substitute good (or a decrease in the price of a complement good) will at the same time raise the demanded quantity.

As consumer income is increased, demand for a normal good will also increase but demand for an inferior good will decrease. A normal good is a good for which demand increases when incomes rise. An inferior good is a good for which demand falls when incomes rise.

As to supply, some factors are assumed as constant. Among them are technology, the input price, as well as degree of government regulation. An im­provement in technology is as important for increasing the supplied quantity of a good as a reduction in input prices.

Government regulates demand and supply, imposing ceiling prices (maximum prices) and floor prices (minimum prices) and adding its own demand to the demand of the private sector.

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A change in demand takes place when one of the factors assumed constant changes. An increase in income results in a rise of the quantity demanded, provided the goods are normal.

A change in the price of one good has an income effect and a substitution effect. The income effect of a price increase is to reduce the quantity demanded of all normal goods. For inferior goods, the income effect works in the opposite direction. The substitution effect leads consumers to buy less of the goods whose price has increased.

The substitution effect of a price rise will also reduce the demand for the goods that are complementary to the goods whose price has risen.

In practice, there are three types of relationships between goods: the goods may be substitutes, complements, or independent. The definition of the three types of relationships is based on the substitution effect of the price change of a good.

(1) The substitution effect is positive for substitute goods, the price of the good (j) and the quantity of the good (i) move in the same direction. If the price of j increases, consumers tend to substitute i for j. If the price of j decreases, then consumers tend to substitute the relatively cheaper j for i. In both cases, there is a positive relationship between the price of j and the quantity of i. An example is butter and margarine.

(2) The substitution effect is negative for complementary goods such as buns and hot dogs. In this case, the price of hot dogs (j) and the quantity of buns (i) move in opposite directions. An increase in price of j (hot dogs) means that the quantity demanded of j decreases and the quantity of the complementary goods i (buns) also decreases. The same happens when the price of j decreases. In both cases there is negative relationship between the price of j and the quantity of i.

Notice what if the goods change places in the equation, it may result in a different coefficient. Let us consider the consumption of sugar and coffee. A change in the price of coffee may have some influence on the use of sugar, but the change in the price of sugar probably will have very little influence on the use of coffee.

(3) The substitution effect is zero for independent goods. Independence means that no substitution or complementary relationship exists between the two goods.

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To have a glimpse in the working of the economy as a whole may be of use to a student of economics.

In every economy there are lots of households to supply labor and capital to firms that use them to produce goods and services. Firms provide incomes for households, who in turn use this money to purchase the goods and services produced by firms. This process is called the circular flow of payments.

The gross domestic product (GDP) is the total money value of all final goods produced in the domestic economy over a one-year period. The GDP can be measured in three ways: (a) the sum of the value added in the production within a year, (b) the sum of incomes received from producing the year's output, (c) the sum to spend on the year's domestic output of goods and services.

The total money value of all final goods and services in an economy over a one-year period, that is the GDP, plus property income from abroad (interest, rent, dividends and profits) make the gross national product (GNP). The GNP is an important measure of a country's economic well-being, while the GNP per head provides a measure of the average standard of living of the country's people. However, this is only an average measure of what people get. The goods and services available to particular individuals depend on the income distribution within the economy.

We now recognize that assets wear out in the production process either physically or become obsolete. This process is known as depreciation. There has to be part of the economy's gross output to replace existing capital, and this part of gross output is not available for consumption, investment, government spending, or exports. So we subtract depreciation from the GNP to arrive at national income.

National income measures the amount of money the economy has available for spending on goods and services after setting aside enough money to replace resources used up in the production process.

Since output is determined by demand, the aggregate demand or spending plans of households and firms determine the level of the output produced, which in turn makes up the income available to households. Aggregate demand is the amount to be spent by firms and households on goods and services.

Governments also step in the circular flow of income and payments. They buy a considerable part of the total output of goods and services in an economy adding their demand to the demand of the private sector. Since government spending is a large component of aggregate demand, and since taxes affect the amount households and companies have for spending, government spending and taxation decisions, which are referred to as⁴ fiscal policy, have major effects on aggregate demand and output.

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Does one characterize a country in economics by the location of economic activity of its population or by the location of its population wherever (где бы ни) such activity may take place? The GNP follows the second method. For example, if a French company owns a factory in Germany, it contributes to the French GNP.

While the GNP depends on who owns property, the GDP depends on location. It is produced by all factors of production within the country, both domestic and foreign owned.

To draw a line between GNP and GDP is not an easy matter as the difference between them is small but there exist interesting exceptions. Switzerland earns a considerable share of its income abroad, which is due to the large number of Swiss-owned multinational companies.

Its GNP has been reported to be more than its GDP by 5 percent.

It is known tat Pakistan, too, has a GNP bigger than its GDP since its large population living abroad regularly transfers labor income to the home country.

Most interesting is Kuwait which has used its oil income over the years to acquire (приобретать) property abroad. As a result of its high investment income, its GNP is known to be bigger than it GDP by 35 percent.

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In most economies government revenues come mainly from direct taxes on personal incomes and company profits as well as indirect taxes levied on purchase of goods and services such as value added tax (VAT) and sales tax. Since state provision of retirement pensions is included in government ex­penditure, pension contributions to state-run social security funds are included in revenue, too. Some small component of government spending is financed through government borrowing.

Government spending comprises spending on goods and services and trans­fer payments.

Governments mostly pay for public goods, that is, those goods that, even if they are consumed by one person, can still be consumed by other people. Clean air, national defense, health service are examples of public goods. Governments also provide such services as police, fire-fighting and the ad­ministration of justice.

A transfer is a payment, usually by the government, for which no cor­responding service is provided in return. Examples are social security, re­tirement pensions, unemployment benefits and, in some countries, food stamps.

In most countries there are campaigns for cutting government spending. The reason for it is that high levels of government spending are believed to exhaust resources that can be used productively in the private sector. Lower incentives to work are also believed to result from social security payments and unemployment benefits.

Whereas spending on goods and services directly exhausts resources that can be used elsewhere, transfer payments do not reduce society's resources. They transfer purchasing power from one group of consumers, those paying taxes, to another group of consumers, those receiving transfer payments and subsidies.

Another reason for reducing government spending is to make room for tax cuts.

Government intervention manifests itself in tax policy which is different in different countries. In the United Kingdom the government takes nearly 40 percent of national income in taxes. Some governments take a larger share, others a smaller share.

The most widely used progressive tax structure is the one in which the av­erage tax rate rises with a person's income level. As a result of progressive tax and transfer system most is taken from the rich and most is given to the poor.

Rising tax rates initially increase tax revenue but eventually result in such large falls in the equilibrium quantity of the taxed commodity or activity that revenue starts to fall again. High tax rates are said to reduce the incentive to work. If half of all we earn goes to the government, we may prefer to work fewer hours a week and spend more time in the garden or watching television.

Cuts in tax rates will usually reduce the deadweight tax burden and re­duce the amount of taxes raised but might increase eventual revenue.

If governments wish to reduce the deadweight tax burden and balance spending and revenue, they are supposed to reduce government spending in order to cut taxes.

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Fiscal policy is an instrument of demand management which is used to influence the level of economic activity in an economy through the control of taxation and government expenditure.

Te government can use the number of taxation measures to control aggregate demand or spending: direct taxes on individuals (income tax) and companies (corporate tax) can be increased if spendings has to be reduced by increasing indirect taxes: an increase in the VAT on all products or excise duties on particular products such as petrol and cigarettes will result in lower purchasing power.

The government can change its own expenditure to affect spending levels as well: a cut in purchases of products or capital investment by the government can reduce total spending in the economy.

 If the government is to increase spending, it creates a budget deficit, reducing taxation and increasing its expenditure.

 A decrease in government spending and an increase in taxes (a withdrawal from the circular flow of national income) reduces aggregate demand to avoid inflation. By contrast, an increase in government spending and/or decrease in taxes (an injection into the circular flow of national income) stimulate aggregate demand and create additional jobs to avoid unemployment.

In practice, however, the effectiveness of fiscal policy can be reduced by a number of problems. Taxation rate changes, particularly changes in income tax, take time to make; considerable proportion of government expenditure on, for example, schools, roads, hospitals and defense cannot easily be changed without lengthy political lobbing.

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Money has four functions: a medium of exchange or means of payment, a store of value, a unit of account and a standard of deferred payment. When used as a medium of exchange, money is considered to be distinguished from other assets.

Money as the medium of exchange is believed to be used in one half of almost all exchange. Workers exchange labor for money, people buy or sell goods in exchange for money as well.

People do not accept money to consume it directly but because it can subsequently be used to buy things, they wish to consume. To see the advan­tages of a medium of exchange, imagine a barter economy, that is, an econ­omy having no medium of exchange. Goods are traded directly or swapped for other goods. The seller and the buyer each must want something the other has to offer. Trading is very expensive. People spend a lot of time and effort finding others with whom they can make swaps. Nowadays, there exist ac­tually no purely barter economies, but economies nearer to or farther from the barter type. The closer is the economy to the barter type, the more waste­ful it is.

Serving as a medium of exchange is presumed to have for centuries been an essential function of money.

The unit of account is the unit in which prices are quoted and accounts are kept. In Britain, for instance, prices are quoted in pounds sterling; in France, in French francs. It is usually convenient to use the same unit to measure the medium of exchange as well as to quote prices and keep ac­counts in. However, there may be exceptions. During the rapid German in­flation of 1922-23 when prices in marks were changing very quickly, German shopkeepers found it more convenient to use US dollars as the unit of ac­count. Prices were quoted in dollars though payment was made in marks. The same goes for Russia and other post-communist economies who used the US dollar as a unit of account, keeping their national currencies as means of actual payment. The higher is the inflation rate, the greater is the probability of introducing a temporary unit of account alongside the existing units for measuring medium of exchange.

Money is a store of value, for it can be used to make purchases in future. For money to be accepted in exchange, it has to be a store of value. Unless suitable for buying goods with tomorrow, money will not be accepted as pay­ments for the goods supplied today. But money is neither the only nor neces­sarily the best store of value. Houses, stamp collections, and interest-bearing bank accounts all serve as stores of value.

Finally, money serves as a standard of deferred payment or a unit of ac­count over time. When money is borrowed, the amount to be repaid next year is measured in units of national currency, pounds of sterling for the United Kingdom, for example. Although convenient, this is not an essential function of money. UK citizens can get bank loans specifying in dollars the amount that must be repaid next year.

Thus, the key feature of money is its use as a medium of exchange. For money to be used successfully as a means of exchange, it must be a store of value as well. And it is usually, though not always, convenient to make money the unit of account and standard of deferred payment.

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The first Russian coins were minted when Russia was converted to Christianity. The gold and silver coins of Kievan Rus were first made under Grand Duke Vladimir Svetoslavovich in the late 10^th – early 11^th century. After a long coinless period, minting was resumed in the 1380s, under Grand Duke Dmitry Donskoy of Moskovy.

The Russian monetary system took shape in the early 16^th century. The main currency unit was the silver kopeck with a depiction of a horseman with a lance; which was Russia’s emblem and the symbol of grand of grand-ducal power. The kopeck’s emergence was connected with the 1535–1538 reform of Yelena Glinskaya, who managed to create the single monetary system for the centralized Russian state.

Later, Peter-the Great brought into circulation coins of various denominations: one-rouble, fifty-kopeck, ten-kopeck, and other coins.

The reform of finance minister Count Kankrin (1839–1854) was the first step towards turning paper banknotes into money backed by the precious metal reserves. The silver rouble was recognized as the principal monetary unit.

During finance minister Sergey Witte’s tenure in office, paper banknotes were backed by gold reserves worth 1,5 billion roubles, and a new monetary economy was set up on the basis of scientifically computed paper money emission rates. Thanks to Witte’s reform, Russia finally managed to integrate into the global financial system. The rouble became convertible.

In the post – 1917 period the first paper banknotes of Soviet Russia were issued. The monstrous hyperinflation of the first years of Soviet power went down once the New Economic Policy was in place and the gold reserves in the country rebuilt. The chervonets, as the new unit equivalent to ten pre-revolutionary roubles was knoen, helped to revive the Russian monetary system founded by Witte. It stayed in circulation until 1928. This year the government resumed its practice of high emission rated, inflation returned and the Soviet Rouble became an exclusively domestic legal tender.

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Inflation is a steady rise in the average price and wage level. The rise in wages being high enough to raise costs of production, prices grow further re­sulting in a higher rate of inflation and, finally, in an inflationary spiral. Peri­ods when inflation rates are very large are referred to as hyperinflation.

The causes of inflation are rather complicated, and there is a number of theories explaining them. Monetarists, such as Milton Friedman, say that inflation is caused by too rapid increase in money supply and the correspond­ing excess demand for goods.

Therefore, monetarists consider due government control of money supply to be able to restrict inflation rates. They also believe the high rate of unem­ployment to be likely to restrain claims for higher wages. People having jobs accept the wages they are being paid, the inflationary spiral being kept under control. This situation also accounts for rather slow increase in aggregate demand.

On the other hand, Keynesians, that is, economists following the theory of John M. Keynes, suppose inflation to be due to processes occurring in money circulation. They say that low inflation and unemployment rates can be ensured by adopting a tight incomes policy.

Incomes policies, though, monetarists argue, may temporarily speed up the transition to a lower inflation rate but they are unlikely to succeed in the long run.

The costs of inflation depend on whether it was anticipated and on (he extent to which the economy's institutions allow complete inflation adjustment.

 The longer inflation continues, the more the economy learns to live with it. Indexation is a means to reduce the costs of some inflation effects. In­dexed wages or loans mean that the amount to be paid or repaid will rise with the price level. Indexation has already been introduced in countries that had to live with inflation rates of 30 or 40 percent for years. And the more coun­tries adjust their economies to cope with inflation, the closer they come to hyperinflation. Indexation means that high rates of inflation are much more likely to continue and even to increase.

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What is now called international trade has existed for thousands of years long before there were nations with specific boundaries. Foreign trade means the exchange of goods and services between nations, but speaking in strictly economic terms, international trade today is not between nations. It is between producers and consumers or between producers in different parts of the globe. Nations do not trade, only economic units such as agricultural, industrial and service enterprises can participate in trade.

Goods can be defined as finished products, as intermediate goods used in producing other goods, or as agricultural products and foodstuffs. In­ternational trade enables a nation to specialize in those goods it can pro­duce most cheaply and efficiently and it is one of the greatest advantages of trade. On the other hand, trade also enables a country to consume more than it can produce if it depends only on its own resources. Finally, trade expands the potential market for the goods of a particular economy. Trade has always been the major force behind the economic relations among nations.

Different aspects of international trade and its role in the domestic economy are known to have been developed by many famous economists. International trade began to assume its present form with the establish­ment of nation-states in the 17th and 18th centuries, new theories of eco­nomics, in particular of international trade, having appeared during this period.

In 1776 the Scottish economist Adam Smith, in The Wealth of Na­tions, proposed that specialization in production leads to increased out­put and in order to meet a constantly growing demand for goods it is necessary that a country's scarce resources be allocated efficiently. Ac­cording to Smith's theory, it is essential that a country trading interna­tionally should specialize in those goods in which it has an absolute ad­vantage - that is, the ones it can produce more cheaply and efficiently than its trading partners can. Exporting a portion of those goods, the country can in turn import those that its trading partners produce more cheaply. To prove his theory Adam Smith used the example of Portuguese wine in contrast to English woolens.

Half a century later, having been modified by the English economist David Ricardo, the theory of international trade is still accepted by most modern economists. In line with the principle of comparative advantage, it is im­portant that a country should gain from trading certain goods even though its trading partners can produce those goods more cheaply. The comparative advantage is supposed to be realized if each trading partner has a prod­uct that will bring a better price in another country than it will at home. If each country specializes in producing the goods in which it has a compara­tive advantage, more goods are produced, and the wealth of both the buying and the selling nations increases.

Trade based on comparative advantage still exists: France and Italy are known for their wines, and Switzerland maintains a reputation for fine watches. Alongside this kind of trade, an exchange based on a competitive advantage began late in the 19th century. Several countries in Europe and North America having reached a fairly advanced stage of industrialization, competitive advantage began to play a more important role in trade. With relatively similar economies countries could start competing for customers in each other's home markets. Whereas comparative advantage is based on location, competitive advantage must be earned by product quality and cus­tomer acceptance. For example, German manufacturers sell cars in the United States, and American automakers sell cars in Germany, both coun­tries as well as Japanese automakers competing for customers throughout Europe and in Latin America.

Thus, international trade leads to more efficient and increased world pro­duction, allows countries to consume a larger and more diverse amount of goods, expands the number of potential markets in which a country can sell its goods. The increased international demand for goods results in greater production and more extensive use of raw materials and labor, which means the growth of domestic employment. Competition from international trade can also force domestic firms to become more efficient through moderniza­tion and innovation.

It is obvious that within each economy the importance of foreign trade varies. Some nations export only to expand their domestic market or to aid economically depressed sectors within the domestic economy. Other nations depend on trade for a large part of their national income and it is often im­portant for them to develop import of manufactured goods in order to supply the ones for domestic consumption. In recent years foreign trade has also been considered as a means to promote growth within a nation's economy-Developing countries and international organizations have increasingly em­phasized such trade.

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Foreign trade is an essential part of nation’s economy and governmental restrictions are sometimes necessary to protect national interests. Government actions may occur in response to the trade polices of other countries or in order to protect specific depressed industries. Since the beginning of foreign trade, nations have tried to maintain a favorable balance of trade – that is, to export more than they import.

Products are bought and sold in the international market with national currencies. Trying to improve its balance of international payments, that is, to increase reserves of its own currency and reduce the amount held by foreigners, a country may attempt to limit imports. The aim of such policy is to control the amount of currency that leaves the country.

One method of limiting imports is simply to close the channels of entry into a country. For this purposes quotas may be set for specific products. They serve as the quickest method of stopping or even reversing a negative trend in a country’s balance of payments and of protecting domestic industries from foreign competition.

Another common way of restricting imports is to impose tariffs or taxes on imported goods. A tariff paid by the buyer of the imported product makes the price higher for that good in the importing country. The higher price reduces consumer demand, effectively restricting the import. The taxes collected on the importing goods also increase revenues for the nation’s government.

In recent years the use of non-tariff barriers to trade has increased. It may be done by some administrative regulations that discriminate against foreign goods in favour of domestic ones. These regulations may include various measures such as adopting special domestic tax policies or strict standards on imported goods, ordering government officers to use domestically produced goods. However, these barriers are not necessarily imposed by a government, for example organized public campaigns “buy only American” or “don’t buy beef of mad cows” may be effective as well.

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Production and Costs

Whether they are film producers of multimillion-dollar epics or small firms that market a single product, suppliers face a difficult task. Producing an economic good or service requires a combination of land, labour, capital, and entrepreneurs. The theory of production deals with the relationship between the factors of production and the output of goods and services.

The theory of production is generally based on the short run, a period of production that allows producers to change only the amount of the variable input called labour. This contrasts with the long run, a period of production long enough for producers to adjust the quantities of all their resources, including capital. The Law of Variable Proportions state that, in the short run, output will change as one input is varied while the others are held constant. The Law of Variable Proportions deals with the relationship between the input of productive resources and the output of productive resources and the output of final products.

 The law helps answer the question: How is the output of the final product affected as more units of one variable input or resource are added to fixed amount of other resources? Of course, it is possible to vary all the inputs at the same time. Economists do not like to do this, however, because when more than one factor of production is varied, it becomes harder to gauge the impact of a single variable on total output.

When it comes to determining the optimal number of variable units to be used in production, changes in marginal product are of special interest.

There are three stages of production – increasing returns, diminishing returns, and negative returns – that are based on the way marginal product changes as the variable input of labour is changed.

In stage one, the first workers hired cannot work efficiently because there are too many resources per worker. As the number of workers increases, they make better use of their machinery and resources. This results in increasing returns (or increasing marginal products) for the first five workers hired. As long as each new worker hired contributes more to total output than the worker before, total output rises at an increasingly faster rate.

This stage is known as the stage of increasing returns.

In stage two, the total production keeps growing, by smaller and smaller amount. This stage illustrates the principle of diminishing returns, the stage where output increases at a diminishing rate as more units of variable input are added.

 The third stage of production begins when the eleventh worker is added. By this time, the firm has hired too many workers, and they are starting  to get in each other's way. Marginal product becomes negative and total plant output decreases.

Measures of Costs

Because the cost of inputs influences efficient production decision, a business must analyze costs before making its decision. To simplify decision making, cost is divided into several different categories.

The first category is fixed cost – the cost that a business incurs even if the plant is idle and output is zero. Total fixed cost, or overhead, remains the same whether a business produces nothing, very little, or a large amount.

Fixed costs include salaries paid to executives, interest charges on bonds, rent payments- on leased properties, and local and state property taxes. Fixed costs also include deprecation, the gradual wear and tear on capital goods over time and through use.

Another kind of cost is variable cost, a cost that changes when the business rate of operation or output changes. Variable costs generally are associated with labor and raw materials.

The total cost of production is the sum of the fixed and variable costs.

Another category of cost is marginal cost – the extra cost incurred when a business producers one additional unit of a product. Because fixed costs do not change from one level of production to another, marginal cost is the per-unit increase in variable costs that stems from using additional factors of production.

The cost and combination, or mix, of inputs affects the way businesses produce. The following examples illustrate the importance of costs to business firms.

Consider the case of a self-serve gas station with many pumps and a single attendant who works in an enclosed booth. This operation is likely to have large fixed costs, such as the cost of the lot, the pumps and tanks, and the taxes and licensing fees paid to state and local governments.

The variable costs, on the other hand, are relatively small.

As a result, the owner may operate the station 24 hours a day, seven days a week for a relatively low cost. As a result, the extra wages, the electricity, and other costs are minor and may be covered by the profits of the extra sales.

Measures of Revenue

Businesses use two key measures of revenue to find the amount of output that will produce the greatest profits. The first is total revenue, and the second is marginal revenue.

The total revenue is the number of units sold multiplied by the average price per unit. The marginal revenue is determined by dividing the change in total revenue by the marginal product.

Keep in mind that whenever an additional worker is added, the marginal revenue computation remains the same. If a business employs, for example, five workers, it produces 90 units of output and generates $ 1,350 of total revenue. If a sixth worker is added, output increases by 20 units, and total revenues increase to $ 1,600. To have increased total revenue by $ 300, each of the 20 additional units of output must have added $ 15.

If each unit of output sells for $ 15, the marginal or extra revenue earned by the sale of one more unit is $ 15 for every level of output.

Marginal revenue can remain constant but businesses often find that marginal revenues start high and then decrease as more units are produced and sold.

Marginal Analysis

Economists use marginal analysis, a type of cost-benefit decision making that compares the extra benefits to the extra costs of an action. Marginal analysis is helpful in a number of situations, including break-even analysis and profit maximization. In each case the costs and benefits of decisions that are made in small, incremental steps.

The break-even point is the total output or total product the business needs to sell in order to cover its total costs. A business wants to do more than break even, however. It wants to make as much profits as it can. But, how many workers and what level of output are needed to generate the maximum profits?

The owner of the business can decide by comparing marginal costs and marginal revenues. In general, as long as the marginal cost is less than the marginal revenue, the business will keep hiring workers.

When marginal cost is less than marginal revenue, more variable inputs should be hired to expand output.

The profit-maximizing quantity of output is reached when marginal cost and marginal revenue are equal.