Profit Maximisation
- Most firms have the rational business objective of profit maximisation
- Profits benefit shareholders as they receive dividends and also increase the underlying share price
- An increase in the underlying share price increases the wealth of the shareholder
- An increase in the underlying share price increases the wealth of the shareholder
- Profits benefit shareholders as they receive dividends and also increase the underlying share price
- To achieve profit maximisation, firms should follow the profit maximisation rule
- When marginal cost (MC) = marginal revenue (MR) then no additional profit can be extracted by producing another unit of output
- When MC < MR additional profit can still be extracted by producing an additional unit of output
- When MC > MR the firm has gone beyond the profit maximisation level of output
- It is making a marginal loss on each unit produced beyond the point where MC = MR
- It is making a marginal loss on each unit produced beyond the point where MC = MR
- In reality, firms may find it difficult to produce at the profit maximisation level of output
- They may not know where this level is
- In the short term, they may not adjust their prices if the marginal cost changes
- Marginal costs can change regularly and regular price changes would be disruptive to customers
- In the long- term, firms will seek to adjust prices to the profit maximisation level of output
- Firms may be forced to change prices by the competition regulators in their country (especially natural monopolies)
- The profit maximisation level of output often results in high prices for consumers
- Changing prices changes the marginal revenue
Diagram: The Profit Maximising Level of Output
The profit maximisation level of output occurs at Q1 where MC = MR resulting in a market price of P1
Diagram analysis
- This firm has market power as the MR and average revenue (AR) curve are downward sloping
- At the profit maximisation level of output (MC = MR)
- The selling price is P1
- The average cost is C1
- The supernormal profit =
Exam Tip
Profit maximisation is all about the quantity of output.
To determine the level of profit:
- identify where MC = MR and then extend the dotted line upwards to the point where it hits the AR curve - this is your selling price
- Where this line crosses the average cost curve (AC) represents the cost per unit at this level of output
- The profit is the difference between the selling price and the average cost
Evaluating Profit Maximisation as a Business Objective
- Apart from the very significant advantages that are offered by pursuing profit maximisation, there are some distinct disadvantages too
The Advantages & Disadvantages of Pursuing Profit Maximisation
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