Profit Maximisation (DP IB Economics)

Normal Profit, Abnormal Profit & Losses

• When calculating costs, Economists consider both the explicit and implicit costs of production

  • Explicit costs are the costs which have to be paid e.g raw materials, wages etc.

  • Implicit costs are the opportunity costs of production

    • This is the cost of the next best alternative to employing the firm's resources

    • E.g. if an investor puts £1m into producing bicycles & they could have put it in the bank to receive 5% interest, then the 5% represents an implicit cost

  • Implicit costs must be considered as entrepreneurs will rationally reallocate resources when greater profits can be made elsewhere
    

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

  • Total costs include explicit and implicit costs
    

• Normal profit occurs when TR = TC 

  • This is also called breakeven
    

• Abnormal profit occurs when TR > TC
  

• A loss occurs when TR < TC

Calculations to Demonstrate Profits

Observations

• Abnormal profit occurs up to the 6th unit of output

• Normal profits occur at the 7th unit

• From the 8th unit, the firm is making a loss

The Profit Maximisation Rule

• 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
       

The Profit Maximisation Rule

• 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
      
      

• 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 government competition regulator

    • 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 =

 
Calculations To Demonstrate the Profit Maximisation Rule

Observations

• With the 7th unit of output, MC = MR & no additional profit can be extracted by producing another unit 

• Up to the 6th unit of output, MC < MR & additional profit can still be extracted by producing an additional unit 

• From the 8th unit of output, 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

Profit & Loss Calculations

• A range of calculations can be made using the above information

• Additionally, average costs and revenues can also be provided from which the per unit cost or revenue can be determined
   

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• Knowledge of the characteristics of perfect and imperfect market structures can also be built into calculations