Q1.

"Profit Maximisation is the main objective of a firm" Discuss this statement with the
help of an example.


The proIit maximization principle stresses on the Iact that the motive oI business Iirms to
maximize proIit is solely justiIied as being a method oI maximizing the income oI their
shareholders.

Firms may maximize proIit by maximizing sales, stock price, market share or cash Ilow. In order
to achieve maximum proIit the Iirm needs to Iind out the point where the diIIerence between
total revenue and total cost is the highest.
The rules that apply Ior proIit maximization are:

1. increase output as long as marginal proIit increases
2. proIit will increase as long as marginal revenue (MR) ~ marginal cost (MC)
3. proIit will decline iI MR MC
4. summing up (ii) and (iii), proIit is maximized when MR MC

A process that companies undergo to determine the best output and price levels in order to
maximize its return . The company will usually adjust inIluential Iactors such as production
costs , sales prices, and output levels as a way oI reaching its proIit goal . There are two main
proIit maximization methods used, and they are marginal Cost-Marginal revenue method and
Total Cost-Total Revenue Method. ProIit maximization is a good thing Ior a company, but can
be a bad thing Ior consumers iI the company starts to use cheaper products or decides to raise
prices.

Economic theory is based on the reasonable notion that people attempt to do as well as they can
Ior themselves, given the constraints Iacing them. For example, consumers purchase things that
they believe will make them Ieel more satisIied, but their purchases are limited (at least in the
long run) by the amount oI income they earn. A consumer can borrow to Iinance current
purchases but must (iI honest) repay the loans at a later date.

Business owners also attempt to manage their businesses so as to improve their well being. Since
the real world is a complicated place, a business owner may improve his well being in a number
oI ways. For example, iI the business doesn't lack customers, the owner could respond by
reducing operating hours and enjoying more leisure. Or, the business owner may seek
satisIaction by earning as much proIit as possible.
This is the alternative we will Iocus on in class - Ior a very good reason. II a business Iaces tough
competition, the only way the business can survive is to pay attention to revenues and costs. In
many industries, proIit maximization is not simply a potential goal; it's the only Ieasible goal,
given the desire oI other businesspeople to drive their competitors out oI business.
In economic terms, proIit is the diIIerence between a Iirm's total revenue and its total opportunity
cost.
Total revenue is the amount oI income earned by selling products. In our simpliIied examples,
total revenue equals P x Q, the (single) price oI the product multiplied times the number oI units
sold. Total opportunity cost includes both the costs oI all inputs into the production process plus
the value oI the highest-valued alternatives to which owned resources could be put.
For example, a Iirm that has $100,000 in cash could invest in new, more eIIicient, machines to
reduce its unit production costs. But the Iirm could just as well use the $100,000 to purchase
bonds paying a 7 rate oI interest. II the Iirm uses the money to buy new machinery, it must
recognize that it is giving up $7000 per year in Iorgone interest earnings. The $7000 represents
the opportunity cost oI using the Iunds to buy the machinery.

We will assume that the overriding goal oI the managers oI Iirms is to maximize proIit: P TR -
TC. The managers do this by increasing total revenue (TR) or reducing total opportunity cost
(TC) so that the diIIerence rises to a maximum.

n Example:
Suppose you are running a business that produces and sells oIIice Iurniture. It's a small
operation, and in a typical day you produce three custom desks. You are able sell these desks Ior
$500 apiece. You employ Iive workers, each oI whom earns $15 per hour ($120 per day), and
you work alongside them and pay yourselI at the same rate. Material inputs cost $150 per desk.
OI course, you have additional "overhead" expenses, including rent, a secretary/bookkeeper,
electricity, etc. This overhead, which we will assume does not vary with the number oI desks
produced (i.e., it's a Iixed cost) comes to $130 per day. Thus, your company earns a proIit oI P
($500 x 3) - ($720 450 130) $1500 - $1300 $200 per day. (Wages Ior six workers come
to $720. Materials Ior three desks cost $450. Overhead is $130.) Working Iive days a week Ior
50 weeks a year, that comes to an annual proIit oI $50,000. Pretty nice - but could you do better?
Suppose you decide to increase production to Iour desks per day. This requires you to hire two
more workers (at another $240) and purchase another $150 worth oI materials. Overhead
expense doesn't change. Your total cost rises to $1690. You Iind that you are able to sell the
Iourth desk Ior $500. Was this a good decision? |Engage brain here.|
You're right. |I'm giving you the beneIit oI the doubt here.| Total revenue rises to $2000 per day,
while total costs rise to $1690. ProIit increases to $310 per day. Good show, old
man/woman/|insert desired politically correct term here|!
This nice result may lead you to increase production to Iive desks a day. II you are able to sell all
Iive desks Ior $500 each, and iI your variable costs oI producing the desks - what you pay in
labor and materials - doesn't increase, producing a IiIth desk makes sense. TR rises to $2500, TC
rises to $2080, and proIit increases to $420. So you sell Iive desks.

Suppose, however, that you Iind that the labor market is so tight that you cannot hire another two
workers at $15 per hour. In Iact, to hire your ninth and tenth workers, you must pay $20 per
hour. That increases the labor cost oI the IiIth desk by $80 ($40 per worker times two workers).
TC rises to $2160, which still allows proIit to increase to $340. But we have a problem brewing.
Can you really get away with paying your veteran workers $15 an hour, while at the same time
hiring new workers at $20 per hour? Not likely. So when you hire the ninth and tenth workers,
you are Iorced to raise the wages oI your Iirst eight workers (Pay yourselI more; hey, you
deserve it.).
Let's recalculate proIit Ior Q 5. TR $500 x 5 $2500. TC ($160 x 10) ($150 x 5) $130
$2480. That leaves a proIit oI $20. Doesn't look like such a good idea now, does it Einstein?
Thus, iI you realize that your costs will rise sharply iI you produce a IiIth desk each day, you will
decline to produce the desk.

Application
Our little example illustrates the situation every business owner or manager Iaces.
Businesspeople know what their current position is (revenue and costs) and they can estimate TR
and TC Ior a higher (or lower) level oI production. By actually changing output levels, they learn
by experience what their demand and cost curves look like. In the process, they discover what
happens to proIit as they change output levels. Through this discovery process, businesspeople
seek to Iind the output level that maximizes proIit.

As omniscient onlookers, we can describe this process a bit more analytically. A Iirm should
increase its output so long as the marginal revenue earned Irom additional units oI production is
greater than the marginal cost oI those units. Marginal revenue is the additional revenue earned
by selling one more unit oI a product. (In our example, MR $500.) Marginal cost is the
additional cost incurred in producing one more unit oI output. So long as MR ~ MC, proIit
grows. However, when MR MC, proIit shrinks. So Iirms expand output only to the point at
which MR MC. This point maximizes proIit.



The proIit-maximization rule applies both to Iirms that are able to sell their product at a constant
price (as in our example) and to Iirms that Iind they must reduce the price oI their product to
increase sales. In the real world, Iirms have to engage in trial-and-error discovery processes,
searching Ior the proIit-maximization point. But the process can be succinctly described by the
marginal revenue-marginal cost rule.

Suppose that Iirm j is perIectly competitive.

ase 1: II the market price Pmkt is greater than the minimum oI Iirm j's average total cost
(ATC) curve, then Iirm j maximizes its short run (SR) proIits at the output level, denoted Qj*,
that satisIies the condition: marginal revenue equals marginal cost (MR MC). In this case, Iirm
j's SR proIits at Qj* are positive and equal to |Pmkt - ATC(Qj*)| x Qj* ~ 0, where ATC(Qj*)
denotes average total cost at Qj*. Note that iI Pmkt equals the minimum oI the ATC curve (Pmkt
ATC(Qj*)), then Iirm j's SR proIits at Qj* are zero and Iirm j is said to be at its SR break-even
point.

ase 2: II the market price Pmkt is between the minimum oI the average variable cost (AVC)
curve and the minimum oI the ATC curve (i.e., min AVC Pmkt min ATC), then a Iirm j
maximizes its SR proIits (i.e., minimizes its loss) at the output level Qj* that satisIies the
condidtion MR MC. In this case, Iirm j's SR proIits at Qj* are negative but its loss at Qj* is
less than its loss iI Iirm j were to shut down and produce zero output, the latter oI which would
be equal to its total Iixed costs, TFC. That is, -TFC j's SR proIits at Qj* |Pmkt - ATC(Qj*)| x
Qj* 0.

ase 3: II the market price Pmkt equals the minimum oI the AVC curve, then Iirm j maximizes
its SR proIits (i.e., minimizes its loss) either at the output level Qj* that satisIies the condition
MR MC or at 0 (zero) output. In this case, Iirm j's SR proIits at either Qj* or 0 are negative and
equal to -TFC and Iirm j is said to be at its SR shutdowm point. That is, j's SR proIits at either
Qj* or 0 output -TFC.

ase 4: II the market price Pmkt is less than the minimum oI the AVC curve, then Iirm j
maximizes its SR proIits (i.e., minimizes its SR losses), at 0 (zero) output. II Qj' is the quantity
that satisIies MR MC, then j's SR loss at Qj'is greater than its SR loss at 0 output, which is
equal to -TFC. Thus, the loss (negative proIits) are minimized at 0 instead oI at the quantity
where MR MC.That is, j's SR proIits at Qj' j's SR proIits at 0 output -TFC 0.