Profit Maximization Theory: Concepts, Computation, and Limits

Introduction to Profit Maximization

Profit is the ultimate goal of every firm. Every firm operates to generate a reasonable amount of profit, which is the difference between the total revenue obtained and the total costs incurred. This drives firms to produce more goods or services; however, every item produced must ultimately be consumed in order to generate profit. In general, it is assumed that firms produce and households consume, and the difference between the cost of production and the revenue generated by consumption is profit.

Profit maximization theory has been further explained by McCann & Vroom (2009, p. 2) as follows: "The assumption of profit maximization as the goal of the firm in strategic management flows naturally from the close connection between strategy and economics. In standard economic theory, resources may either be consumed by individuals or used by firms in production. Consumption takes place in the household while production takes place within the firm. Households derive utility from consumption, so household decisions are driven by utility maximization. In contrast, firms do not derive utility directly from production, so firm decisions are driven by profit maximization."

Computing Profit Maximization

In general, profit maximization is computed as the difference between revenue and costs:

Profit = Total Revenue − Total Cost

However, for a more accurate picture, profit maximization should be computed using marginal revenue and marginal cost. Marginal revenue is the revenue obtained by selling one additional unit of a product — the extra money that one more item will bring to the firm. Marginal cost, on the other hand, is the cost incurred by a company to increase production by one unit. True profit is therefore the difference between marginal revenue and marginal cost, because a firm attains price equilibrium when marginal cost equals marginal revenue:

Profit = Marginal Revenue − Marginal Cost

If marginal revenue is less than marginal cost, the result is a loss to the firm. This equation can also be used to determine whether a company should increase or decrease its production to gain maximum profits. If marginal revenue is greater than marginal cost, every extra unit is generating additional profit, and the firm should increase production. Conversely, if marginal cost exceeds marginal revenue, the firm is spending more money on each extra unit than it is earning, so production should be reduced to maximize profits.

Cost Curves and Graphical Representation

This relationship can be illustrated with a cost-curve diagram. In such a diagram, cost is plotted on the y-axis and quantity on the x-axis. ATC (average total cost) represents the total cost of all units produced divided by total quantity. AVC (average variable cost) is the total variable cost divided by total quantity. AFC (average fixed cost) is the total fixed costs divided by quantity.

Variable costs — such as labor, electricity, and power — increase as the firm expands production. Fixed costs — such as rent and administrative expenses — remain constant regardless of output, so the average fixed cost per unit decreases as production rises. As a result, in the diagram, AFC falls as quantity increases, while AVC rises. The marginal cost curve also slopes upward as production increases. The shaded region in the diagram represents the firm's profit. The price line serves simultaneously as the marginal revenue and the average revenue for the firm.

The firm earns profit only in the range where marginal cost is below marginal revenue (the shaded portion). Once marginal cost rises above marginal revenue, the firm incurs a loss and must reduce output. At the profit-maximizing quantity, marginal revenue and marginal cost are exactly equal.

Conclusion

In short, profit maximization theory in economics provides a sound framework for understanding the levels of production or supply required to attain maximum profits. It supplies the fundamentals upon which a firm can build its profit-maximizing strategy. However, its applicability in the real world is limited by the reasons discussed above — namely, the unrealistic assumption of perfect competition, the complexity of owner-manager utility, and the dynamics of market entry and exit.

References

McCann, Brian T. & Vroom, Govert. (2009). Ownership structure, profit maximization, and competitive behavior. Academy of Management Proceedings, 1–6.

Nagurney, Anna. (2010). Supply chain network design under profit maximization and oligopolistic competition. Transportation Research, Part E, 46(3), 281–294.

Mankiw, Gregory N. (2009). Principles of Economics. Mason, OH: South-Western Cengage Learning.