MR=MCThe optimising condition

(or how do firms maximise profit?)

What shall we do today, Sam?

Lets go make a profit!

What is the purpose of a firm?Most economic theory is based on the idea that all economic agents act in their rational self-interest to maximise their utility.

In plain English this means that we assume people earn as much as possible to be able to buy what they want, that governments aim to increase wealth and wellbeing in the nation and that businesses try to make as much profit as possible.

The idea that firms profit maximise is a fundamental assumption underpinning the neo-classical Theory of the Firm.

Evaluation

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 may pursue career advancement, company growth or the achievement of bonuses.

Organisational theories emphasise the competing needs of stakeholders and the conflict between these objectives. This conflict results in compromise, perhaps accepting less than maximum profit in return for better working conditions for employees.

Hmmm... how do I make the maximum profit?

I know that profit is the difference between my revenue and the total cost of making the products, so...

Total profit = Total Revenue – Total Cost

But how many products do I have to make to get the biggest difference between revenue and costs?

Not sure, but what I do know is if I can sell more than I do now at a profit then I should increase production. But if I have to reduce price so much to sell more that these products make a loss then I shouldn't increase output.

Alfred isn't a genius but he can work out that he needs to sell as many products as possible as long as each one he sells adds to the profit of the business. This is known as the optimising condition.

The Alfred testAlfred's business is making 1000 products a week. Should he increase production to 1001? Here are the facts...

To sell the 1001st product Total Revenue would increase by £5.00

Total Cost would increase by £4.80

What should Alfred do?

Susan's bright ideaSusan is the Production Manager for the business. She has a bright idea. The business has enough equipment to produce 1100 products a week. Susan thinks they should make good use of the firm's capacity by increasing production to this level.

To increase sales to 1100 products the total revenue would increase by £200

The Total Costs would increase by £240

Should Alfred accept Susan's suggestion?

Alfred's dilemma leads us to two common sense conclusions;

1. Don't increase output unless your profit increases

2. Decrease your output if you could make more profit

In other words, produce at the level at which you profit maximise.

Without realising it, Alfred is using the concepts of marginal revenue (MR) and marginal cost (MC) to make his decision. Marginal revenue is the additional revenue received by the firm for increasing output by one unit. Marginal cost is the additional cost added by supplying one more unit.

In the example, MR of the 1001st unit is £5.00 and MC is £4.80. Therefore the firm can increase its profit by increasing output. We can express the conclusions above by using 'marginal language'.

Where MR>MC the firm should increase output

Where MR<MC the firm should decrease output

If firms behave in their rational self-interest they will reach an equilibrium level of output whereby marginal revenue equals marginal cost, or where...

MR=MC

COMMON MISTAKE ALERT

Marginal revenue is not the same as the price charged for the next product. To sell an extra product it may be necessary to reduce the price of all products (if the firm can't price discriminate), therefore the firm will gain the revenue of selling another product but lose the revenue of reducing prices overall. The same goes for costs. By making more products the average cost of producing each product may fall. Therefore the 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 assumption that firms understand the behaviour of revenue and costs in their business. In other words it assumes perfect information on behalf of the firm. In reality it is very difficult to calculate the optimal level of production. The market price may change frequently, costs may fluctuate, productivity varies from day to day and the firm may be charging different prices to different customers.

BEWARE THE WEIRD DEFINITION

Why would a firm produce an extra product if the additional revenue (MR) would be equal to the additional cost (MC)? In other words, why produce that extra product if there is not extra profit to be gained? To understand the reason for wanting to produce a product where MR=MC we need to understand that the economists definition of 'total cost' includes a level of 'normal profit'. The 'cost' of production includes the 'cost' of rewarding the investor for placing their capital in the business.

Normal versus Supernormal

Normal profit is the minimum level of profit necessary to keep firms in the market. Without a minimal level of profit investors will withdraw their funds and place them instead in a market which offers better returns.

However, as normal profit is so unimpressive new firms will not be attracted into the market.

Economists consider normal profit to be a cost of production as it is the cost of keeping investors interested.

Supernormal profit (also known as abnormal or above-normal profit) is enough to attract new firms into the market. New firms will take a share of these profits and eventually all firms will 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 also assumes no barriers to entry into markets where supernormal profit is available. Remember the Theory of the Firm is a neo-classical theory. This means it is built on assumptions about how 'perfectly competitive' markets operate.

You can't do economics without a diagram...Now it's time to apply the theory. We have learnt that to maximise profit a firm should apply the MR=MC optimising condition. By examining a firms revenue and cost structure we 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 of market it is assumed that the individual firm has to set the ruling market price and therefore its demand curve is perfectly elastic. We also assume that the average and marginal costs of production falls at low levels of output due to increasing marginal returns and increases as diminishing marginal returns take effect. The model looks like this...

Graphic courtesy of Tutor2u

The firm's 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 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. The supernormal profit will act as a signal to firms who will respond to this incentive by entering the market. The increase in supply in the market (represented by a shift to the right in the market diagram below) pushes down the equilibrium price. The individual firm must take this ruling market price (remember we assume that consumers choose only the cheapest good and have perfect knowledge of the prices charged by firms). The firm's revenue curve shifts downwards until MR=MC=AC. The firm is making a normal profit and this signals that there are no excess profits remaining and no more firms will enter the market.

The firm's output is still determined by the MR=MC rule.

However, at the new price level the firm's total revenue equals its total cost.

Therefore it only makes a 'normal' profit.

SummaryTHE OPTIMISING CONDITION Firms aim to maximise profit This is achieved where at the output where the difference between total revenue and total costs is at its greatest Or where Marginal Revenue equals Marginal Cost (MR=MC)

APPLYING THE THEORY Firms should produce a level of output where MR=MC The profit at this level of output is determined by the difference between Average Revenue and Average Cost multiplied by the level of output In a perfectly competitive market firms may make supernormal profits in the short run if there are too few firms in the market In the long run the supernormal profit signals to firms to enter the market which reduces profit levels to 'normal'

USING THE THEORY We can use this knowledge to work out what level of output a firm should set to maximise profit We can also examine the behaviour of a market to see whether firms in the market are behaving in their rational self interest i.e. producing at a level which will maximise profit Knowing how firms 'should' behave in a perfectly competitive market we can look for evidence of what actually happens and draw conclusions about how close to the model of perfect competition the market actually is

QUESTIONNING THE THEORY Do firms always pursue a profit maximising objective? Do firms possess sufficient information to make rational decisions about their output? Do real-world markets ever meet the conditions of perfect competition?