1. Profit maximisation
Profits are maximised when marginal revenue = marginal cost
Price Per Unit (AR)
(£)
Demand /
Output
(units)
Total
Revenue (TR)
(£)
Marginal
Revenue (MR)
(£)
Total
Cost (TC)
(£)
Marginal
Cost (MC)
(£)
Profit
(£)
50 33 1650 2000 -350
48 39 1872 37 2120 20 -248
46 45 2070 33 2222 17 -152
44 51 2244 29 2312 15 -68
42 57 2394 25 2384 12 10
40 63 2520 21 2444 10 76
38 69 2622 17 2480 6 142
36 75 2700 13 2534 9 166
34 81 2754 9 2612 13 142
Consider the example in the table above. As price per unit declines, so demand expands.
Total revenue rises but at a decreasing rate as shown by the column showing marginal
revenue. Initially the firm is making a loss because total cost exceeds total revenue. The firm
moves into profit at an output level of 57 units. Thereafter profit is increasing because the
marginal revenue from selling units is greater than the marginal cost of producing them.
Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost
is £9 per unit. Profits increase from £142 to £166.
But once marginal cost is greater than marginal revenue, total profits are falling. Indeed
the firm makes a loss if it increases output to 93 units.
As long as marginal revenue is greater than marginal cost, total profits will be increasing (or
losses decreasing). The profit maximisation output occurs when marginal revenue = marginal
cost.
Profits are
decreasing when
MR < MC
Marginal Revenue
Marginal Cost
Q1
Revenue
And Cost
Output (Q)
Profits are
increasing when
MR > MC

2. In the next diagram we introduce average revenue and average cost curves into the diagram
so that, having found the profit maximising output (where MR=MC), we can then find (i) the
profit maximising price (using the demand curve) and then (ii) the cost per unit.
• The difference between price and average cost marks the profit margin per unit of
output.
• Total profit is shown by the shaded area and equals the profit margin multiplied by
output
The short run supply decision - the shut-down point
A business needs to make at least normal profit in the long run to justify remaining in an
industry but in the short run a firm will continue to produce as long as total revenue covers
total variable costs or price per unit > or equal to average variable cost (AR = AVC). This is
referred to as the shutdown price.
The reason for this is as follows. A business’s fixed costs must be paid regardless of the level
of output. If we make an assumption that these costs cannot be recovered if the firm shuts
down then the loss per unit would be greater if the firm were to shut down, provided variable
costs are covered.
Costs
Revenue
Output (Q)
SRAC
AR
(Demand)
MR
SRMC
Q1
P1
AC1
Supernormal profits at
Price P1 and output Q1
AC2
Q2
Normal profit at Q2 where
AR = AC

3. Consider the cost and revenue curves facing a business in the short run in the diagram above.
 Average revenue (AR) and marginal revenue curves (MR) lies below average cost
across the full range of output, so whatever output produced, the business faces
making a loss.
 At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut
down as price is less than AVC. The loss per unit of producing is vertical distance AC.
 If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.
 In the short-run, provided that the price is greater than or equal to P2, the business can
justify continuing to produce in the short run.
Case Study: Northern Foods decides to mothball a factory
Northern Foods, which supplies Marks and Spencer, is to mothball a factory making ready-meals
because it is no longer economical. They said that, whilst the plant had been profitable in recent years
it was no longer generating enough money to give an adequate return to shareholders. Some analysts
have argued that the decision might be due to the effects of the monopsony power of Marks and
Spencer which has demanded discounts of up to 6% from its top suppliers including Northern Foods.
Source: Adapted from news reports, May 2008
Case Study: Bitter blow for beer drinkers as pubs call last orders
It is a bitter blow for the licensed trade but 1.2 million fewer pints of beer are being drunk every day
in Britain this year compared to last and over forty pubs a week are calling last orders for the final
time. The British Beer & Pub Association blames mounting costs - including pub rents, wages and higher
wholesale prices for beers and other drinks - together with sinking sales due to falling consumer
confidence, higher beer prices and impact of the smoking ban. But the biggest villains of the peace
according to the pubs are the major supermarkets whose cheap beer has created a significant price
wedge between the cost of drinking at home or having a few jars down the local.
Source: Tutor2u economics blog, May 2009
Recession and factory closures
Costs,
Revenues
Output (Q)Q1
MC
AVC
AR
MR
P1
AC1
A
B
C
P1 is below average variable cost
P2
ATC

4. The concept of the shutdown point has become topical this year due to the recession. Many
manufacturing businesses have opted to close down loss-making production plants and
retailers have announced the closure of retail outlets in a bid to cut their losses. Some of the
plant closures have been temporary, for example some high-profile car manufacturers
mothballed their factories and reduced the number of shifts. But for other businesses, the
downturn has brought about an end to trading. Recent years have seen the demise
of a large, well-known retailers including Zaavi, Comet and Woolworths.

5. Deriving the Firm’s Supply Curve in the Short Run
• In the short run, the supply curve for a business operating in a competitive market is the
marginal cost curve above average variable cost.
• In the long run, a firm must make a normal profit, so when price = average total cost,
this is the break-even point. It will therefore shut down at any price below this in the
long run.
• As a result the long run supply curve will be the marginal cost curve above average
total cost.
The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a
monopoly is a price-maker, not a “passive” price-taker, and can thus select the price and
output combination on the demand curve so as to maximise profits where marginal revenue =
marginal cost.
Changes in demand and the profit maximising price and output
A change in demand and/or production costs will lead to a change in the profit maximising
price and output. In exams you may often be asked to analyse how changes in demand and
costs affect the equilibrium output for a business. Make sure that you are confident in drawing
these diagrams and you can produce them quickly and accurately under exam conditions.
In the diagram below we see the effects of an outward shift of demand from AR1 to AR2
(assuming that short run costs of production remain unchanged). The increase in demand causes
a rise in the market price from P1 to P2 (consumers are now willing and able to buy more at a
given price perhaps because of a rise in their real incomes or a fall in interest rates which has
increased their purchasing power) and an expansion of supply (the shift in AR and MR is a
signal to firms to move along their marginal cost curve and raise output). Total profits have
increased.

6. Costs
Output (Q)
AC
AR1
(Demand)
MR1
MC
Q1
P1
AC1
Profit Max at Price P1
P2
AC2
Q2
Profit Max at Price P2
AR2
MR2
A rise in demand (a shift in AR and MR) causes an expansion of supply, a higher profit maximising
price and an increase in supernormal profits

7. The Functions of Profit in a Market Economy
Profits serve a variety of purposes to businesses in a market-based economic system
1. Finance for investment Retained profits are source of finance for companies
undertaking investment. The alternatives such as issuing new shares (equity) or bonds
may not be attractive depending on the state of the financial markets especially in the
aftermath of the credit crunch.
2. Market entry: Rising profits send signals to other producers within a market. When
existing firms are earning supernormal profits, this signals that profitable entry may be
possible. In contestable markets, we would see a rise in market supply and lower
prices. But in a monopoly, the dominant firm(s) may be able to protect their position
through barriers to entry.
3. Demand for factor resources: Scarce factor resources tend to flow where the expected
rate of return or profit is highest. In an industry where demand is strong more land,
labour and capital are then committed to that sector. Equally in a recession, national
output, employment, incomes and investment all fall leading to a squeeze on profit
margins and attempts by businesses to cut costs and preserve their market position. In
a flexible labour market, a fall in demand can quickly lead to a reduction in
investment and cut-backs in labour demand.
4. Signals about the health of the economy: The profits made by businesses throughout
the economy provide important signals about the health of the macroeconomy. Rising
profits might reflect improvements in supply-side performance (e.g. higher productivity
or lower costs through innovation). Strong profits are also the result of high levels of
demand from domestic and overseas markets. In contrast, a string of profit warnings
from businesses could be a lead indicator of a macroeconomic downturn.
Real GDP Growth (Top) and Net rate of return on capital employed (Bottom)
Business Profits and the Economic Cycle
Source: CBI Manufacturing Survey
99 00 01 02 03 04 05 06 07 08
millions
6
8
10
12
14
16
18
Rateofreturn(%)(millions)
6
8
10
12
14
16
18
Manufacturing
Service Sector Industries
ManufacturingServices
-5
-4
-3
-2
-1
0
1
2
3
4
5
%changeinGDP
-5
-4
-3
-2
-1
0
1
2
3
4
5

8. Steps to higher profits
In an ideal world, running a business would be easy! You come up with an innovative idea,
create a new product or service so popular you can’t stop people from buying it. Word
spreads and, before you know it, sales and profits are growing. In reality, few businesses are
able to sit back and watch the profits roll in. Creating and increasing profitability depends on
doing a hundred little things better than the existing competition. So what are the best ways for
a business to increase its profitability?
Method 1: Grow the “Top Line”
Every business and every market is different. But for most businesses, the best long-term way
to improve profitability is to increase sales (also known as “turnover”). This is for four main
reasons:
1. If a business has a high gross profit margin, every extra sale is profitable. Once your
turnover reaches the break-even level then each additional sale adds to profits.
2. Acquiring new customers is made easier by greater market presence and reputation.
As you grow, unit costs are reduced through economies of scale.
3. If your customers tend to be loyal, the value of each new customer lays not just in the
immediate sale, but in future sales as well. The cost of selling to existing customers is
always lower than the cost of acquiring new customers.
4. Defending a market share against competitors is easier than defending high profit
margins.
Many businesses operate in what are called “low growth” markets - where expansion only
comes by taking a bigger share of the available demand. Low growth markets tend to be in
markets where income elasticity of demand is low, so that as the real incomes of consumers
increase, there is little positive effect on market demand.
Method 2: Keep Costs under Control
If a business has a low gross profit margin, reducing direct costs increases the profit on each
sale. Eliminating overheads has an immediate impact on profit. Every business can increase
profitability by reducing hidden costs. Hidden costs include the costs of employing
inappropriate people since poor recruitment can lead to lower quality, increased training
costs and ultimately redundancy costs.
Suggestions for further reading on profits
The recession has hit profits in many businesses and industries, but not every business suffers a
slump in profitability during an economic downturn. Here is a selection of recent news articles
on the profitability of businesses in different markets and industries and how changes in
demand and costs affect prices and profits.
Burger King Profits grow strongly (BBC news, April 2009)
Dominos delivers strong profits (BBC news, February 2009)
Downturn hits sports giant Nike (BBC news, June 2009)
Honda profits slump as sales fall (BBC news, April 2009)
PC maker Dell’s profits slump (BBC news, May 2009)
Profits fall at Gregg’s bakeries (BBC news, March 2009)