The process by which businesses and enterprises determine strategies to make more profits with lower expenditure is called profit maximization. It is a fundamental target of every firm and is crucial for their progress.
Read on to find detailed explanations on topics like producer’s equilibrium and how it affects the profit maximization formula.
Cost, Revenue, and Profit
The expenditure of a firm that goes into the manufacture of products or delivery of services is known as its Total Cost of Production (TC). The income of a firm from the sale of its products and services is called its Total Revenue (TR).
The difference between Total Cost of Production (TC) and Total Revenue (TR) constitutes the profit of the company. Therefore, profit, denoted by \[\pi\], can be calculated as
\[\pi = TR - TC\]
What is Profit Maximization?
The primary target of any company is typically assumed to be churning maximum profit out of their business since that is the only way for a firm to thrive.
The process by which enterprises regulate the manufacture, cost, and output levels that will call for the greatest profits is referred to as profit maximization.
Producer’s Equilibrium
In order for a business to achieve maximum profits, it has to reach a stage of equilibrium. A firm or producer is said to have attained equilibrium when its level of output gives rise to the maximum difference between total revenue and total cost, and it has no disposition to change its existing level of production. This state is a reflection of either maximum profits or minimize losses.
How can a Producer Maximize Profits in Perfect Competition?
In a perfectly competitive market, an organization can have a say over the number of units they want to manufacture and sell, provided they do so at constant prices fixed by the industry to which their commodity belongs. This way, consumers can buy as many numbers of units as they wish at an unfaltering market price, and the company has a perfectly elastic demand curve for services and products.
When a firm gets to decide the number of commodities it wants to produce, this quantity in addition to prevalent market prices of input and output is what governs mentioned enterprise’s total cost of production, total revenue, and, hence, total profits.
There are two methods of determining profit maximization in perfect competition, as have been mentioned below. 1. Comparison Between Total Cost and Total Revenue
As discussed earlier, the difference between total revenues and total costs constitutes the total profits of a firm. Therefore, with increasing sales of components at a given price, there will be an increase in total revenue. Total profits will keep reaching heights as long as the change in total revenue continues to exceed the change in the total cost of production.
In this scenario, what firms in perfect competition can do is figure out the exact quantity of commodities that need to be sold in order to earn maximum profits.
Take the case of a raspberry farm, for instance, which sells each packet of frozen raspberries for \[$4\]. Accordingly, the sale of 1 pack will bring \[$4\], 2 packs will bring \[$8\], 3 packs will bring \[$12\], and so on. In case, the price of each pack rises to \[$8\], the sale of 1 pack will bring \[$8\], 2 packs will bring \[$16\], 3 packs will bring \[$24\], and so on, that is, with an increasing market price, change in total revenue will also increase.
Refer to the following table to understand how a comparison between total cost (TC) and total revenue (TR) of the raspberry farm works for profit maximization in relation to varying output levels.
The same has been graphically represented to help you visualize change in total profits better.
In the above figure, the vertical axis represents total costs and total revenues in terms of $, while the horizontal axis represents the number of raspberry packs produced and sold. A perfectly competitive firm can calculate the output level for maximum profit by figuring out the point where total revenue exceeds total cost by the highest amount. 2. Comparison Between Marginal Revenue and Marginal Cost
An alternative to the afore-mentioned method of determining maximum profit is the MR MC approach.
The change in Total Cost of Production with the manufacture of an additional unit is termed as Marginal Cost (MC). It is mathematically represented as
MC = Change in total cost / Change in quantity = \[\frac{\Delta TC }{\Delta Q }\]
Similarly, the change in Total Revenue resulting from the sale of an additional unit is known as Marginal Revenue (MR). It can be calculated as:
MR = Change in total revenue / Change in Quantity = \[\frac{\Delta TR }{\Delta Q }\]
A firm in a perfectly competitive market has a perfectly elastic demand graph, which means its MR curve is exactly similar to its demand curve. This states that every time there is a demand for an additional unit that company products meet, its revenue increases by an exact amount equal to the prevailing market price. With reference to the mentioned raspberry farm in perfect competition, with the purchase of every raspberry pack, $4 gets added to the farm's revenue, that is, MR does not vary with an increase in production units.
Marginal cost, on the other hand, goes through an obvious change with an increased quantity of production.
Following is an illustration of how the quantity of production units affects marginal revenue and marginal cost.
Here, it can be observed that marginal costs decrease at first with an increase in production. At levels where MR > MC, increased output levels add more to profit.
The ideal level of output for maximum profit is when MR = MC.
Do You Know?
Why is profit maximized when MR = MC? This is because, at production levels of MR = MC, the difference between TR and TC is maximum, which is our requirement for producer’s equilibrium, leading to profit maximization. However, in the above table, profits begin to fall again after this level when MC > MR. Therefore, MC < MR is a necessary condition for sustained profit after this level.
Profit maximization is a crucial topic in Class 12 Commerce and comes with a bunch of complex concepts important for board exams. For further explanation on the profit maximization model, install the Vedantu app today.
The level of sales in which the profits are the highest is referred to as profit maximization. It can be assumed that if the level of the sales is high, the profits can be high as well but it is not true in all cases. The profit maximization can be calculated by-
the number of units where the Marginal Revenue (MR) is equal to the Marginal Cost (MC)
Profit Maximization in Perfect Competition
When there are many firms selling to many buyers with perfect information about the homogeneous goods, the situation of Perfect Competition arises. Under perfect competition, as none of the firms can individually influence the price of the goods that are to be purchased or sold therefore the firm is the price taker. The output levels to maximize profits are chosen to be the objective of each perfectly competitive firm. The most primary goal is to calculate the optimal level of output when the Marginal Cost (MC)= Market Price (MP) in order to maximize profit in a perfectly competitive firm.
In a graph having competitive firm output q in the x-axis, and the price of the commodity in the y-axis, the point where the MC intersects with MR or P is the profit maximization point. In case a quantity exceeding \[q_{0}\] is produced by a competitive firm, then the MR and \[P_{0}\] would be less than MC and there would not incur any economic loss in the firm on the Marginal unit. Hence the firm by decreasing its outputs till it reaches\[q_{0}\] can increase its profits. If there is a production of a quantity less than \[q_{0}\] then the MC would be greater than MR and P₀ and in this case, profit would be incurred but not to its maximum and hence the firm could increase the profits by increasing the output till it reaches \[q_{0}\].
FAQs on Profit Maximization Strategies in Business
1. What are the main strategies a business can use to maximize profit?
A business primarily uses two types of strategies to maximize profit. The first involves increasing Total Revenue (TR), which can be achieved through effective marketing, adjusting product prices, or expanding into new markets. The second involves decreasing Total Cost (TC) by improving operational efficiency, using technology to automate tasks, or negotiating better terms with suppliers. The most effective approach often combines both revenue enhancement and cost control measures.
2. What is the primary rule for profit maximization for a firm?
The primary rule for profit maximization is that a firm should produce at the level of output where its Marginal Revenue (MR) equals its Marginal Cost (MC). Marginal Revenue is the additional income from selling one more unit, while Marginal Cost is the additional cost of producing that unit. Producing at the point where MR = MC ensures that the last unit produced contributes exactly as much to revenue as it does to cost, thereby maximizing the total profit.
3. How do you calculate the profit-maximizing level of output?
To determine the profit-maximizing quantity of output, a business should follow these steps as per the marginal approach:
- First, calculate the Marginal Revenue (MR) and Marginal Cost (MC) for each successive unit of output.
- Next, identify the exact quantity where MR is equal to MC.
- Finally, confirm that at this level of output, the Marginal Cost is rising. This ensures it is a point of maximum profit, not minimum. The quantity that satisfies these conditions is the ideal profit-maximizing output.
4. What is the difference between marginal cost and marginal revenue?
Marginal Revenue (MR) represents the change in a firm's total revenue that results from selling one additional unit of a product. In contrast, Marginal Cost (MC) represents the change in the firm's total production cost incurred from making one additional unit. A firm uses these two metrics to make production decisions: if MR is greater than MC, it is profitable to produce more, but if MR is less than MC, production should be reduced.
5. Why is the condition 'Marginal Cost must be rising' necessary for profit maximization?
The condition that Marginal Cost (MC) must be rising at the point where MR = MC is essential to distinguish a profit maximum from a loss-making situation. If MC were falling when it equaled MR, producing any further units would mean MC would drop below MR, making additional production even more profitable. A rising MC curve guarantees that for any unit produced beyond the MR=MC point, the cost of that unit (MC) will exceed the revenue it generates (MR), confirming that profit was indeed maximized at that specific quantity.
6. Can a business maximize profit by simply increasing its selling price? Explain.
Not always. While increasing the price per unit seems like a direct path to higher profit, it usually causes a decrease in the quantity demanded by consumers. The final impact on total profit depends on the price elasticity of demand. If demand for the product is inelastic (consumers are not sensitive to price changes), a price hike can increase total revenue. However, if demand is elastic (consumers are very price-sensitive), a price hike will cause a significant drop in sales, leading to lower total revenue and reduced profit.
7. Beyond the MR=MC rule, what are some practical, real-world examples of profit maximization strategies?
In practice, businesses implement several real-world strategies to maximize profit, including:
- Price Discrimination: Offering the same product at different prices to different segments, such as student discounts on software or peak/off-peak airline ticket prices.
- Cost Leadership: Focusing on becoming the lowest-cost producer in an industry through scale, efficiency, and waste reduction, a model famously used by large retail chains.
- Technological Innovation: Investing in research and development to create superior products that can be sold at a premium or to automate processes that lower production costs.
- Product Bundling: Selling multiple products together for a single price, which can increase the overall sales value and reduce marketing costs per item.
8. Is profit maximization always the main goal for a modern business? What are the arguments against it?
While profit maximization is a core objective, it is often not the only goal for a modern business. Critics argue that an exclusive focus on profit can lead to negative consequences like poor employee treatment, environmental neglect, and unethical practices. Therefore, many contemporary businesses also prioritize other objectives such as wealth maximization (focusing on the company's long-term value), Corporate Social Responsibility (CSR), building strong customer loyalty, and ensuring the satisfaction of all stakeholders, not just shareholders.
