Profit Maximisation (DP IB Economics)
Revision Note
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
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5 | 150 | 70 | 80 |
6 | 180 | 96 | 84 |
7 | 220 | 220 | 0 |
8 | 250 | 270 | -20 |
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 =
Examiner Tip
Profit maximisation is all about the quantity of output.
To determine the level of profit from a diagram:
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
Calculations To Demonstrate the Profit Maximisation Rule
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5 | 50 | 32 | +18 |
6 | 50 | 36 | +14 |
7 | 50 | 50 | 0 |
8 | 50 | 68 | -18 |
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
Knowledge of the characteristics of perfect and imperfect market structures can also be built into calculations
Worked Example
Instants PLC is producing at a level of output equal to 3000 units per month, and its costs and revenues are shown in Table 1.
Table 1
Average total cost (ATC) | $64 |
Marginal cost (MC) | $64 |
Average revenue (AR) | $60 |
Marginal revenue (MR) | $60 |
Price (P) | $60 |
Average variable cost (AVC) | $56 |
Answers:
a) Using the data in Table 1, state the reason why Instants PLC is operating in a perfectly competitive market. [1]
The demand curve is perfectly elastic as P = AR = MR
b) Determine whether Instants PLC is producing at the profit-maximising (loss-minimising) level of output. You must give a reason for your choice. [2]
The firm is not producing at the profit maximisation level of output (1 mark) as MC ≠ MR (1 mark)
c) Using Table 1, calculate the total fixed costs incurred by Instants PLC at the current level of output, Q1. [2]
Total Costs (TC) = 3,000 x $64 = $192,000
Total variable cost (TVC) = 3,000 x $56 = $168,000 (1 mark for any valid working)
Total fixed costs (TFC) = TC - TVC
Total fixed costs (TFC) = $192,000 - $168,000 = $24,000 (1 mark)
d) Using Table 1, calculate the monthly profit or loss Instants PLC is making at the current level of output [2]
Profit = total revenue - total costs
Profit = (3,000 x $60) - (3,000 x $64) (1 mark for any valid working)
Profit = 180,000 - 192,000
Profit = -$12,000 (the firm is making a loss of $12,000) (1 mark)
e) Determine whether Instants PLC is productively efficient. You must give a reason for your choice. [2]
The firm is productively efficient (1 mark) as the ATC = MC (1 mark)
f) Determine whether Instants PLC is allocatively efficient. You must give a reason for your choice. [2]
The firm is not allocatively efficient (1 mark) as the price (AR) ≠ MC (1 mark)
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