The process by which businesses and enterprises determine strategies to make more profits with lower expenditure is called profit maximisation. 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 profit maximisation formula.
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 profit of the company. Therefore, profit, denoted by π, can be calculated as:
π = TR – TC
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 greatest profits is referred to as profit maximisation.
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 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 minimum losses.
In a perfectly competitive market, an organisation 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 quantity 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 maximisation in perfect competition, as have been mentioned below.
Comparison Between Total Cost and Total Revenue
As discussed earlier, the difference between total revenues and total costs constitutes 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 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, 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 maximisation in relation to varying output levels.
The same has been graphically represented to help you visualise change in total profits better.
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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 highest amount.
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 = ∆TC / ∆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 = ∆TR / ∆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 prevailing market price. With reference to mentioned raspberry farm in perfect competition, with purchase of every raspberry pack, $4 gets added to 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 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.
Why is profit maximised 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 maximisation. 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 maximisation 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 maximisation model, install the Vedantu app today.
Q1. What are the conditions for Profit Maximisation?
Ans. The two conditions for profit maximisation are – (1) MR=MC, and (2) MC<MR after that level.
Q2. Mention some benefits of Profit Maximisation Theory.
Ans. Benefits of profit maximising theory include – (1) It ensures profit which is essential for a thriving business, (2) Meeting profits ensures achievement of business target and, hence, enhances performance, (3) Increased profits lead to increased cash flow which benefits the workforce and other contributing industries.
Q3. How do you calculate Profit Maximising Quantity?
Ans. Calculate marginal cost (MC) by dividing the given change in total cost (TC) by change in the quantity of output. Set marginal revenue (MR) equal to marginal cost and determine quantity (Q) that needs to be produced to specified MR. This is your profit maximising quantity.