In economics it is often assumed that companies try to maximize profit. That is, they try to maximize revenue while at the same time minimizing costs. In order to do that, firms need to look "at the margin". That means, they have to keep an eye on changes in revenue (i.e. marginal revenue) and changes in costs (i.e. marginal costs) for every additional unit sold.
To introduce the principle of profit maximization, it seems reasonable to focus on firms in a competitive market first. However, as we will see later on, this principle can be applied to most firms in various market situations (monopoly, oligopoly, etc.).
As mentioned above, to maximize profits, a firm needs to examine changes in revenue and costs for every additional unit sold. As long as the resulting increase in revenue is larger than the increase in costs, total profit can still be raised by producing more. This will hold true until marginal revenue (MR) equals marginal cost (MC). In other words, a profit maximizing firm will produce until MR=MC.
This can be illustrated by looking at a simple diagram that shows the relations between output and costs or revenue respectively. Though, before we can do this, we need to find out what the relevant marginal cost and marginal revenue curves look like.
Computing marginal revenue in a competitive market is actually pretty simple. In fact, it is always equal to the price of the good or service sold.To explain this, we shall look at a characteristic of competitive firms. They are said to be price takers. That is, they do not have enough power to influence market prices (unlike for example a monopolist), since they only control a small share of the market. So no matter how much a competitive firm produces, price will not change and revenue for each additional unit sold will be equal to the given market price. As a result, the marginal revenue curve will be a horizontal line at the level of the market price.
Most firms face increasing marginal costs as output increases. This is a result of diminishing marginal products.To give an example, think of a car factory that is currently producing at a low capacity. There are only few workers employed and the machines are barely used. If the factory increases production, idle capacities can easily be put to use and additional workers can add a lot of value. In other words, marginal costs are low and marginal product is high. However, if the factory is already running at full capacity, increasing production will be more expensive (e.g. because machines are overused) and additional workers will not add much value (e.g. because they have to wait to use equipment). Therefore, when output increases, marginal product diminishes and marginal cost increases. As a result, the marginal cost curve will slope upwards.
As mentioned above, we can visualize the principle of profit maximization in a simple diagram (see below). The x-axis represents output quantity (Q), while the y-axis stands for costs and revenue respectively (C and R).
|Illustration 1: Profit Maximization|
The Marginal revenue curve (MR) is a horizontal line at the level of the market price (p*). The marginal cost curve on the other hand (MC) is upward sloping, as described above. The intersection of the two lines (O*) is located at the profit maximizing level of output (q*) for the given price level. It becomes apparent that shifting MR will affect the output quantity, but not the price level. Thus, profit maximization for competitive firms means, finding the optimal level of output for a given price.