MR=MCThe optimising condition (or how do firms maximise profit?)
Lets go make Evaluation What shall we a profit! do today, Sam? There are two alternatives to this view of a firms objectives. Managerial Theories are based on the assumption that the firm will pursue objectives that are in the interest of the managers – after all, they are in charge! Managers mayWhat is the purpose of a firm? pursue career advancement, companyMost economic theory is based on the idea that all economic growth or theagents act in their rational self-interest to maximise their achievement of bonuses.utility. Organisational theories emphasise theIn plain English this means that we assume people earn as competing needs ofmuch as possible to be able to buy what they want, that stakeholders and thegovernments aim to increase wealth and wellbeing in the nation conflict between theseand that businesses try to make as much profit as possible. objectives. This conflict results in compromise, perhaps accepting lessThe idea that firms profit maximise is a fundamental than maximum profit inassumption underpinning the neo-classical Theory of the return for better workingFirm. conditions for employees.
Hmmm... how do I make the maximumprofit?I know that profit is the difference betweenmy revenue and the total cost of making theproducts, so...Total profit = Total Revenue – Total CostBut how many products do I have to maketo get the biggest difference betweenrevenue and costs?Not sure, but what I do know is if I can sell Alfred isnt a genius but hemore than I do now at a profit then I should can work out that he needs toincrease production. But if I have to reduceprice so much to sell more that these sell as many products asproducts make a loss then I shouldnt possible as long as eachincrease output. one he sells adds to the profit of the business. This is known as the optimising condition.
The Alfred testAlfreds business is making 1000 products a week. Should he increase production to 1001? Here arethe facts...To sell the 1001st product Total Revenue would increase by £5.00Total Cost would increase by £4.80What should Alfred do?Susans bright ideaSusan is the Production Manager for the business. She has a bright idea. The business has enoughequipment to produce 1100 products a week. Susan thinks they should make good use of the firmscapacity by increasing production to this level.To increase sales to 1100 products the total revenue would increase by £200The Total Costs would increase by £240Should Alfred accept Susans suggestion?
Alfreds dilemma leads us to two common sense conclusions;1. Dont increase output unless your profit increases2. Decrease your output if you could make more profitIn other words, produce at the level at which you profit maximise.Without realising it, Alfred is using the concepts ofmarginal revenue (MR) and marginal cost (MC) tomake his decision. Marginal revenue is the additional If firms behave in theirrevenue received by the firm for increasing output by rational self-interest theyone unit. Marginal cost is the additional cost added by will reach an equilibriumsupplying one more unit. level of output whereby marginal revenue equalsIn the example, MR of the 1001st unit is £5.00 and MC marginal cost, oris £4.80. Therefore the firm can increase its profit by where...increasing output. We can express the conclusionsabove by using marginal language.Where MR>MC the firm should increase output MR=MCWhere MR<MC the firm should decrease output
COMMON MISTAKE ALERTMarginal revenue is not the same as the price charged for the nextproduct. To sell an extra product it may be necessary to reduce the priceof all products (if the firm cant price discriminate), therefore the firm willgain the revenue of selling another product but lose the revenue ofreducing prices overall. The same goes for costs. By making moreproducts the average cost of producing each product may fall. Thereforethe marginal cost is the overall increase or decreases in total costs.WARNING – DODGY ASSUMPTION!The belief that firms behave in this way is underpinned by the assumptionthat firms understand the behaviour of revenue and costs in theirbusiness. In other words it assumes perfect information on behalf ofthe firm. In reality it is very difficult to calculate the optimal level ofproduction. The market price may change frequently, costs may fluctuate,productivity varies from day to day and the firm may be charging differentprices to different customers.BEWARE THE WEIRD DEFINITIONWhy would a firm produce an extra product if the additional revenue (MR)would be equal to the additional cost (MC)? In other words, why producethat extra product if there is not extra profit to be gained? To understandthe reason for wanting to produce a product where MR=MC we need tounderstand that the economists definition of total cost includes a level ofnormal profit. The cost of production includes the cost ofrewarding the investor for placing their capital in the business.
Normal versus SupernormalNormal profit is the minimum level of profitnecessary to keep firms in the market. Withouta minimal level of profit investors will withdrawtheir funds and place them instead in a marketwhich offers better returns.However, as normal profit is so unimpressivenew firms will not be attracted into the market.Economists consider normal profit to be a costof production as it is the cost of keepinginvestors interested.Supernormal profit (also known as abnormal orabove-normal profit) is enough to attract newfirms into the market. New firms will take ashare of these profits and eventually all firmswill tend towards a normal level of profit.EvaluationHow close is this theory to what actually happens? Do all firms in all markets make normal profits?The theory assumes perfect knowledge on behalf of investors about the profits available. It alsoassumes no barriers to entry into markets where supernormal profit is available. Remember theTheory of the Firm is a neo-classical theory. This means it is built on assumptions about howperfectly competitive markets operate.
You cant do economics without a diagram...Now its time to apply the theory. We have learnt that to maximise profit a firm shouldapply the MR=MC optimising condition. By examining a firms revenue and cost structurewe should be able to predict what level of output the firm will tend towards.We will model the effect of these rules in a perfectly competitive market. In this type ofmarket it is assumed that the individual firm has to set the ruling market price and thereforeits demand curve is perfectly elastic. We also assume that the average and marginal costsof production falls at low levels of output due to increasing marginal returns and increasesas diminishing marginal returns take effect. The model looks like this... The firms output is determined by the MR=MC rule. At this level of output the profit is represented by the shaded area. The profit is the difference between the average revenue and average cost, multiplied by the Graphic courtesy of Tutor2u level of output.
Can this supernormal profit be sustained in the long run?In a perfectly competitive market new firms are free to enter or leave the market. Thesupernormal profit will act as a signal to firms who will respond to this incentive by enteringthe market. The increase in supply in the market (represented by a shift to the right in themarket diagram below) pushes down the equilibrium price. The individual firm must takethis ruling market price (remember we assume that consumers choose only the cheapestgood and have perfect knowledge of the prices charged by firms). The firms revenuecurve shifts downwards until MR=MC=AC. The firm is making a normal profit and thissignals that there are no excess profits remaining and no more firms will enter the market.The firms output isstill determined bythe MR=MC rule.However, at the newprice level the firmstotal revenue equalsits total cost.Therefore it onlymakes a normalprofit.
SummaryTHE OPTIMISING CONDITION USING THE THEORY Firms aim to maximise profit We can use this knowledge to work out what This is achieved where at the output level of output a firm should set to maximisewhere the difference between total revenue profitand total costs is at its greatest We can also examine the behaviour of a Or where Marginal Revenue equals market to see whether firms in the market areMarginal Cost (MR=MC) behaving in their rational self interest i.e. producing at a level which will maximise profit Knowing how firms should behave in aAPPLYING THE THEORY perfectly competitive market we can look for Firms should produce a level of output evidence of what actually happens and drawwhere MR=MC conclusions about how close to the model of The profit at this level of output is perfect competition the market actually isdetermined by the difference betweenAverage Revenue and Average Costmultiplied by the level of output QUESTIONNING THE THEORY In a perfectly competitive market firms Do firms always pursue a profit maximisingmay make supernormal profits in the short objective?run if there are too few firms in the market Do firms possess sufficient information to make In the long run the supernormal profit rational decisions about their output?signals to firms to enter the market which Do real-world markets ever meet the conditionsreduces profit levels to normal of perfect competition?