2.2 - profit maximization, PED, PES, YED,

profit maximization

the process of increasing profit by determining the most effective level of production and pricing strategy.

marginal costs = marginal revenue

→ beyond this point with each unit produced marginal loss occurs

p1 = selling price

c1 = average cost

super-normal profit = total revenue> total costs

advantages of profit maximization

• enables financial stability and growth

• enhances shareholder values

• efficient allocation of resources

• drives innovation and competitiveness

disadvantages of profit maximization

• ethical and social concerns

  • may neglect long-term sustainability and employee welfare.

• lack of knowledge about the point of profit maximization

• often results in higher prices for consumers

growth

an increase in the capacity of an economy to produce goods and services over time, often measured by GDP.

price elasticity of demand

• measure of how responsible the quality demanded is to a change in its price

• indicates consumers’ sensitivity to price changes

• price↑ = demand ↓

price elasticity of demand formula

PED = % change in quantity demanded / % change in price

interpreting PED values

determinants of PED

• availability of substitutes ↑ = PED ↑

• addictiveness of the product ↑ = PED↓

• price of products as proportion of income ↓ = PED ↓

  • consumers are less responsive to price changes of cheap products

• time period

  • short term = low PED

  • long term = high PED

total revenue rule

to maximize revenue businesses should

• increase the price of products that are inelastic in demand

  • big increase in price results in small decrease in demand

• decrease the price of products that are elastic in demand

  • small decrease in price results in big increase in demand

income elasticity of demand YED

• measures the responsiveness of demand for a product to changes in consumer income

• positive YED indicates that a good is a normal good,

• negative YED signifies an inferior good.

• influenced by factors that affect the wages

  • minimum wage

  • taxes

YED formula

YED = % change in quantity demanded / % change in income

YED values

inferior goods

• YED<0

• income ↑ = demand ↓

normal goods

• YED>0

  • income↑ = demand↑

luxury goods

• YED> 1

  • income↑ = demand↑↑

price elasticity of supply PES

• measures the responsiveness of the quantity supplied of a good to changes in its price.

• higher PES value indicates that supply is more responsive to price changes.

PES formula

PES = % change in quantity supplied / % change in price

PES values

0 → perfectly inelastic/ unresponsive

0-1 → relatively inelastic

1→ relatively elastic

1-∞→ perfectly elastic/fully responsive

determinants of PES

production time ↑= PES↑

availability of resources↑ = PES ↑

flexibility of the production process = PES ↑

profit maximisation

profit = marginal (total) revenue - marginal (total) costs

break even/ normal profit

total revenue = total costs

abnormal profit

total revenue > total costs

profit loss

total revenue < total costs

profit maximisation rule

a firm should continue producing additional units until

• marginal costs MC = marginal revenue MR