Concept of Profit Maximization
Profit can be defined as the difference between revenue earned from selling a product and the cost of producing that product. In economics, the excess of revenue over costs is called “pure profit” or “economic profit”. Symbolically, P=R-C (where P denotes profits, R denotes revenue and C denotes Cost). When the difference between R and C is greatest, profit is also maximized. Total profit would depend upon total cost and total revenue and marginal cost would depend upon marginal cost and marginal revenue.
Therefore, “Profit Maximization” can be defined as the process of determining the optimal price as well as optimal output, for a firm, enabling it to earn maximum returns or profit.
Profit maximization is the foremost objective of a firm. Firms operate in order to earn highest revenue possible. They are required to adjust their production costs, product prices and output levels in order to reach their desired profit target. Hirshleifer (1980) writes, “According to the classical formulation, the aim of the firm as a decision-making agent is to maximize (economic) profit” (p.
Let us first define the important terms that shall be used in this particular study of profit maximization.
· Total Fixed Cost is the total cost incurred on those factors, the quantity of which cannot be changed in the short-run. For example, capital invested, rent, insurance are fixed costs.
· Total Variable Cost is the total cost incurred on those input factors, the quantity of which can be changed in the short-run. Examples of variable costs include wages paid to workers, expenditure on raw material, expenditure on fuel and power, etc.
· Marginal cost is the cost of producing one more unit of output. It is the addition to total cost as one more unit of output is produced.
· Average Cost is the per unit average cost of each factor used in production.
· Average Revenue is the per unit revenue of the product. It is derived by dividing total revenue by the total output.
· Marginal Revenue is the addition to total revenue which results from the sale of one additional unit of the product.
Rules for Profit Maximization: Since a firm operates to earn profits, it is said to be in equilibrium at the point where its profits are maximum or losses are minimum. The rules that must be satisfied in order for a firm to be earning maximum profits are:
1. Decision of whether to produce or not in the short run-
A firm has to incur fixed costs in the short run, even if it decides to shut down its operations completely. This is why certain firms continue to operate in spite of incurring losses. Thus, in order to resolve whether or not to produce in the short run, a firm ought to compare its losses under two scenarios, i.e. losses when the firm chooses to shut down and losses when the firm continues production. Only if the losses during production are less than or equal to the losses in the event of a shut down should the firm continue production. Otherwise, it would be more prudent for the firm to stop production. In other words, a firm should continue production only if Average Revenue is at least equal to the Average Variable Cost because in that case losses during production will be equal to or less than losses if the firm shuts down.
Illustration: Let us assume that the Average Revenue (AR) of Product A is 10. Its Fixed Cost (FC) is 8 and its Average Variable Cost (AVC) is 12. Under these circumstances, AR of Product A will not be able to cover even its AVC. Hence, it will be more judicious to stop production of Product A.
However, if the AR of Product A is 10, the FC is 8 the AVC is 6, AR of Product A can cover its AVC and part of the FC and it would be better for the firm to continue its production as the losses in production would be less than losses in case of shut down.
To summarize, the first rule of profit maximization is that a firm should produce only when the Average Revenue is greater than or equal to Average Variable Cost.
2. Profits must be maximum-
Once the first rule has been satisfied and the firm decides that it would be more profitable to continue production, it is required to determine how much output it wants to produce. Clearly a firm would want to produce an output that would maximize its profits. Profit maximization output would be the one where Marginal Revenue (MR) is equal to Marginal Cost (MC).
The logic behind this rule is that if the Marginal Revenue is greater than Marginal Cost, it indicates that the production of one more unit of output is adding more to the revenue than to the cost. This would, of course, increase profits. The firm must increase output in this case because if it ceases to produce more at this point, it would not be maximizing its profits. If, on the other hand, the firm discovers that the cost of producing one more unit of output (MC) is greater than the revenue derived from selling it (MR), it would signify that the additional unit is reducing profits. The firm would increase profits by reducing production.
Illustration: Assume that the Marginal Cost (MC) of the product of Firm A is 10 and the Marginal Revenue is 12. The production of more units would result in increase in profits. Therefore, it would be sagacious to produce more units now.
Alternatively if the MC of the product is 10 and the MR is 8, it would serve the firm to reduce its output since the addition of one more unit of the product to output is resulting in an increase in cost more than an increase in revenue. Consequently, the outcome of more output is a decrease in profits.
Thus if the Marginal Revenue is more than Marginal Cost, the firm should increase production to maximize profits and if the MR is lesser than MC, the firm should decrease production to increase profits. However, if MR is equal to MC, the firm should neither increase nor decrease production as at this point it is maximizing its profits.
Accordingly, the second rule of profit maximization can be encapsulated as thus- For a firm to be producing its profit-maximization output, it must produce at that point where Marginal Revenue is equal to Marginal Cost.
3. Ensuring that profits are maximized and not minimized-
The equivalence of Marginal Cost and Marginal Revenue is one of the conditions under which profits would be maximized. Nevertheless, there are instances when equality between MC and MR results in a minimization of profits. Under such a condition, the following rule would apply.
The third rule can be explained with the help of the graph below.
In the above graph, the price or revenue is depicted on the X axis. The Y axis represents the output. The MC curve denotes the Marginal Cost while the MR curve denotes the Marginal Revenue.
Here MC is equal to MR at two places, once at the output level of Q1 and second at the output level of Q2. Output Q1 is the minimum profit level since any increase or decrease from this level would result in an increase in profits. If output is increased from Q1, MC would be lesser than MR, signifying an increase in profits. Q2 is the profit maximizing output level. Any change, no matter how slight, from this position would result in a decline of profits. If output is increased slightly from Q2, MC would become greater than MR, meaning a reduction in profit. On the other hand, if output is reduced from Q2, MR would be greater than MC, which implies that output can be raised to increase profits.
Geometrically, it can be said that the MC curve should intersect MR curve from below so that MC is less than MR to the left of the profit-maximizing output and greater than MR to the right of the profit-maximizing output.
Thus, the third rule of profit maximization states that profit is maximized at the point of output where Marginal Revenue is equal to Marginal Cost and where Marginal Cost would be lower than Marginal Revenue at slightly lesser output and more at a higher output.
The above mentioned rules ensure that a firm is producing output which reaps the highest possible profit. Every firm that wishes to maximize profits must abide by and incorporate these rules.
Importance of Profit Maximization and its relation to Economics:
The first and foremost objective of an organization is to make money. Money is imperative for the growth and proper functioning of all enterprises. The more money it generates, the more successful the organization is considered. The concept of profit maximization makes certain that a firm is earning the maximum returns or profit. Profit maximization relates to economics as it deals with the costs and revenues on a microeconomic level. Profit maximization is used by firms to determine the price and output for their products. Depending on the type of competition that prevails, whether perfect, imperfect, monopolistic or oligopolistic, the producer has to determine the profit-maximizing output. Therefore the concept of profit maximization is an essential decision making tool. According to Anderson and Ross (2005), “While the MR = MC profit-maximizing model that is used almost religiously
by the economics profession has been challenged over the years, it still remains the dominant model to explain firm behavior.”
Black, J., 2002. Profit Maximization. A Dictionary of Economics.
Anderson W. & Ross R., 2005. The Methodology of Profit Maximization: An Austrian Alternative. The Quarterly Journal of Austrian Economics, 8 (4), pp 31-44.
Warburton & Christopher, 2006. Research and Profit Maximization in Finance and Economics.
Sethi D. & Andrews U., 2004. Frank ISC Economics, 5th ed., New Delhi, Frank Bros & Co. Publishers Ltd.
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