Profit & Revenue Maximisation
Profit Maximisation
- Most firms have the rational business objective of profit maximisation
- Profits benefit shareholders as they receive dividends & 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 & also increase the underlying share price
- To achieve profit maximisation firms, 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 Commission
- The profit maximisation level of output often results in high prices for consumers
- Changing prices changes the marginal revenue
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 =
Revenue Maximisation
- Some firms have the business objective of revenue maximisation
- This often occurs due to the principal agent problem
- Sales managers often receive commission on sales as part of their wages and this incentivises them to maximise sales
- Profit maximisation for shareholders becomes a secondary objective for the sales managers
- Firms will also maximise revenue in order to increase output & benefit from economies of scale
- In the short-term firms may use this strategy to eliminate the competition as the price is lower than when focussing on profit maximisation
- This often occurs due to the principal agent problem
- To achieve revenue maximisation firms produce up to the level of output where MR = 0
- When MR > 0, producing another unit of output will increase total revenue
- When MR > 0, producing another unit of output will increase total revenue
The revenue maximisation level of output occurs at Q1 where MR = 0 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 revenue maximisation level of output (MR = 0)
- The selling price is P1
- The average cost is C1
- The supernormal profit =
- The supernormal profit is less than when the firm follows the profit maximisation rule
Exam Tip
Profit and revenue 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