Profit Maximisation (DP IB Economics)

Revision Note

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Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

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


Output


TR (£)


TC (£)

 
Profit (TR - TC)

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

3-2-1-profit-maximisation-image_edexcel-al-economics

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 =left parenthesis straight P subscript 1 space minus space straight C subscript 1 right parenthesis space cross times space straight Q subscript 1

Examiner Tips and Tricks

Profit maximisation is all about the quantity of output.

To determine the level of profit from a diagram:

  1. 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

  2. Where this line crosses the average cost curve (AC) represents the cost per unit at this level of output

  3. The profit is the difference between the selling price and the average cost

 
Calculations To Demonstrate the Profit Maximisation Rule


Output


MR (£)


MC (£)

 
Addition to Profit

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
     

  • begin mathsize 14px style Average space cost space equals space fraction numerator total space cost over denominator number space of space units end fraction end style
     

  • Average space revenue space equals fraction numerator space total space revenue over denominator number space of space units space sold end fraction

  • 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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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.