Wednesday, 14 November 2012

Principles of Economics: Profit Maximisation (Microeconomics)

Today's post will look at the profit maximisation for a firm. There really isn't that much too this, but I'll dedicate a post to it none the less. If you refer back to the post relating to a firm's revenue it will make what's about to be explained a lot easier. The main rule to remember here is that the profit maximising point for a firm is where the marginal revenue and marginal cost are equal. Why this point? Well, as long as marginal revenue is greater than marginal cost more profit can be made by increasing production. At the point where marginal revenue equals marginal cost, no more profit can be made and therefore this point will be the profit maximisation point.

Diagram time!

Profit maximisation is shown on this diagram here. We've set up a simple model of a firm's revenue and costs. Then, at the point MC = MR we have drawn a line up. This gives us two prices, P1 and P2. P1 is the actual market price for the good or service. P2 is the cost to produce that certain good. Therefore, using simple logic we can work out the actual price. P1 - P2 will give us the profit made on each good produced and then if we multiply this by the quantity we will have total supernormal profit. Or, visually it's the gold area on the diagram.

Notice I used the phrase supernormal profit. There are actually two levels of profit, normal profit and supernormal profit. Normal profit is the cost of staying in the industry; so this is essentially the minimum amount the firm needs to make in order to stop them leaving the industry. It will include such things as the pay for the entrepreneur. Supernormal profit is anything above this level, any additional income for the firm. A situation can also occur when the average cost curve is higher than the average revenue curve, if you picture this in your head and you'll see it'll result in a loss. In the short term some firms will not worry about this if they are using it as a technique to reduce competition or something similar. In this case nothing changes, the firm will still produce at the point MC = MR, however the only change is this time we'll call it the loss-mining position/quantity. 

Sorted! Profit maximsation and loss minimisation for you! Hope it helps, feedback and comments are of course always welcomed! Thank you guys, have a good evening.


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