2.11 (2) Profit Maximisation

Explicit costs

Explicit costs are business costs that firms incur in their operations.

→ into factors of production

Implicit costs

• An implicit cost is the opportunity cost that exists in every business decision-making situation.

Opportunity costs of using your own resources in one way instead of the next best alternative.

→ what you sacrifice by NOT choosing the next best alternative.

PROFIT

• = total revenue (TR) - total costs (TC)

• Total costs include explicit and implicit costs

NORMAL PROFIT

• Occurs when TR = TC 

• Called breakeven

ABNORMAL PROFIT

• Occurs when TR > TC

→ firm earns more revenue than all its costs

→ extra profit remains after paying all costs

• A loss occurs when TR < TC

→ firms revenue not enough to cover costs

Why do firms aim to maximise profit?

• Most firms aim to maximise profit as a rational business objective

• Higher profits benefit shareholders through:

  • dividends

  • higher share prices

• Rising share prices increase shareholder wealth

The Profit Maximisation Rule

• MC = MR

→ no additional profit can be gained by producing another unit of output

→ here should stop producing more

• MC < MR

→ producing one extra unit costs LESS than the revenue earned from selling it.

→ firms still gains extra profit from producing more

• MC > MR

→ Cost of producing one extra unit is GREATER than the revenue gained from selling it.

→ producing more REDUCES profit

→ the firm has gone beyond profit maximisation.

Why may firms struggle to produce at the profit maximisation level of output?

1. Firms may not know exact MC and MR

• costs and revenues constantly change

• difficult to calculate exact profit-maximising output

2. Firms do not constantly change prices

• customers dislike constant price changes

• it may confuse or annoy consumers

3. Changing prices changes MR

• consumers buy different quantities

• revenue changes

4. Government regulators may intervene

• very high prices

• abuse market power

→ price changes forced

How do firms adjust toward profit maximisation in the long run?

• Firms aim to maximise profit in the long run

• They adjust price, output and costs to produce where:

  MC=MR

• If profits are high, firms may expand production and new firms may enter the market

• If firms make losses, they reduce costs/output or leave the industry

• In the long run, firms seek greater efficiency and sustainable profit levels

Diagram Profit Maximisation

Digaram Analysis

• Firm has market power as the MR and average revenue (AR) curve are downward sloping

• Profit maximisation level of output (MC = MR)

  • The selling price is P₁

  • The average cost is C₁ and AC

  • The supernormal profit = ( P1 - C1) X Q1

SUPERNORMAL PROFIT P > AC