# In the real world, how does a firm know their marginal costs and revenue? How do they mathematically calculate MC=MR?

I understand the theory behind it but in practice how is this done?

According to the orthodox economist, in the real world, firms do not consciously try to calculate $$MC$$ or $$MR$$. Nor do they consciously try to produce/sell at the point where $$MC=MR$$.

Instead, the theory you have learnt is simply theory. This theory argues that:

If firms are maximizing profits, then they must be producing/selling at the point where $$MC=MR$$.

This theory does not claim that firms consciously seek to produce/sell at the point where $$MC=MR$$. Indeed, most firms do not.

Nonetheless, the orthodox economist claims that thanks to the discipline of competitive markets, firms are forced to maximize profits and thus forced to produce/sell at the point where $$MC=MR$$. And so, as a simplifying assumption, we may assume that firms act as if they are seeking to produce/sell at the point where $$MC=MR$$.

Here is one such orthodox economist (Milton Friedman, 1953) explaining this at length with the use of the analogy of the billiards player:

Consider the problem of predicting the shots made by an expert billiard player. It seems not at all unreasonable that excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas that would give the optimum directions of travel, could estimate accurately by eye the angles, etc., describing the location of the balls, could make lightning calculations from the formulas, and could then make the balls travel in the direction indicated by the formulas. Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that, unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players.

It is only a short step from these examples to the economic hypothesis that under a wide range of circumstances individual firms behave as if they were seeking rationally to maximize their expected returns (generally if misleadingly called "profits") and had full knowledge of the data needed to succeed in this attempt; as if, that is, they knew the relevant cost and demand functions, calculated marginal cost and marginal revenue from all actions open to them, and pushed each line of action to the point at which the relevant marginal cost and marginal revenue were equal. Now, of course, businessmen do not actually and literally solve the system of simultaneous equations in terms of which the mathematical economist finds it convenient to express this hypothesis, any more than leaves or billiard players explicitly go through complicated mathematical calculations or falling bodies decide to create a vacuum. The billiard player, if asked how he decides where to hit the ball, may say that he "just figures it out" but then also rubs a rabbit's foot just to make sure; and the businessman may well say that he prices at average cost, with of course some minor deviations when the market makes it necessary. The one statement is about as helpful as the other, and neither is a relevant test of the associated hypothesis.

Confidence in the maximization-of-returns hypothesis is justified by evidence of a very different character. This evidence is in part similar to that adduced on behalf of the billiard-player hypothesis-unless the behavior of businessmen in some way or other approximated behavior consistent with the maximization of returns, it seems unlikely that they would remain in business for long. Let the apparent immediate determinant of business behavior be anything at all-habitual reaction, random chance, or whatnot. Whenever this determinant happens to lead to behavior consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not, the business will tend to lose resources and can be kept in existence only by the addition of resources from outside. The process of "natural selection" thus helps to validate the hypothesis-or, rather, given natural selection, acceptance of the hypothesis can be based largely on the judgment that it summarizes appropriately the conditions for survival.

An even more important body of evidence for the maximization-of-returns hypothesis is experience from countless applications of the hypothesis to specific problems and the repeated failure of its implications to be contradicted. This evidence is extremely hard to document; it is scattered in numerous memorandums, articles, and monographs concerned primarily with specific concrete problems rather than with submitting the hypothesis to test. Yet the continued use and acceptance of the hypothesis over a long period, and the failure of any coherent, self-consistent alternative to be developed and be widely accepted, is strong indirect testimony to its worth. The evidence for a hypothesis always consists of its repeated failure to be contradicted, continues to accumulate so long as the hypothesis is used, and by its very nature is difficult to document at all comprehensively. It tends to become part of the tradition and folklore of a science revealed in the tenacity with which hypotheses are held rather than in any textbook list of instances in which the hypothesis has failed to be contradicted.

• thank you for that, I understand it now – Daniel Troncoso Apr 28 '19 at 0:35
• I wonder why firms need economists. – ahorn Apr 29 '19 at 17:03

In practice, the company (manufacturer) usually plans their quantity of product for next year in Q4, based on the remaining capacity and the demand of their clients (including outstanding clients and new orders estimated by their sales staffs).

In general, the company puts high priority for run in line with demand of market, instead of optimizing the cost by mc=mr as in theory.

However, some huge corporations, which have stable and big revenue sufficient to cover cost of collecting information input for optimizing manufacturing cost, may apply that formular in their operation. I have not worked at such company so far so I do not make sure about that.