Profit maximisation (MC=MR)
Profit maximization occurs at the point where marginal cost is equal to marginal revenue. One of the main reasons why firms may want to operate at the profit maximization point is in order to keep shareholders happy. By increasing the profit that the firm makes it allows room for an increase in the dividends paid out to shareholders. In addition to this, the earnings report will show this large amount of profit made and which will make the firm’s stock more appealing to buy, thus pushing up its stock price. This also benefits the shareholders.
Another reason why a firm may want to profit maximise is to use some of the profit in order to reinvest into the business. This is a much cheaper option than loaning money as it does not need to be paid back with interest. They can then use this money to expand and grow organically.
However, there are also some reasons why a firm may not operate at the profit maximization point. One of which is the fact that the firm may not know the point at which MC=MR is. Therefore, they may set their prices either above or below the profit maximization point.
Another reason why some firms may not profit maximise is in order to minimize the risk of investigation from the competition and markets authority. A firm operating at the profit maximization point is not acting in the consumer’s interest. This can be seen on the diagram by the high price (P1) and the low quantity (Q1) (meaning that there is a lack of choice). The competition and markets authority may see this as consumer exploitation and therefore take regulatory action that takes the firm away from the profit maximization point e.g. by forcing them to lower their prices.
The diagram below shows the profit maximization point (MC=MR). In order to find out the profit maximization price level, draw a line from MC=MR vertically up to the AR/Demand, as shown on the diagram. The cost of producing at this point is also shown at the point vertically up from MC=MR where the line touches the average cost curve. Therefore, the supernormal profit that the firm makes can be shown in the box area. This is the price (p1) minus the average cost at producing at that point multiplied by the quantity (Q1). Firms operating at the profit maximization point will charge a high price (P1) and produce a small quantity of goods/services (Q1).
Revenue maximisation (MR=0)
Revenue maximization takes place at the point where the marginal revenue is equal to 0. This can be seen on the diagram. Although the firm is making some profit at this point, that is not always the case.
One of the main reasons for a firm to revenue maximise is to drive out competition. This can be shown in the diagram by the competitively low price that they’re offering their goods/services at (P1). At this price point it may be hard for other firms to match their price and if they do they may make a loss, forcing them out the market. If they cannot meet the price and therefore stay with their higher prices, they are likely to lose customers which again may force them out the market. Whether or not competitors can match the revenue maximization price will be determined by the firm’s average costs and whether or not they’re low enough to break even or make a profit at that price point. This is directly affected by the extent to which they experience economies of scale.
Another reason why firms may revenue maximise is in order to experience economies of scale. This can be shown in the diagram by the high quantity of output that occurs during revenue maximization (Q1). As the firm grows and sells more goods/services they will experience some of the benefits of being big e.g. paying less interest back on loans.
Sales maximisation (AC=AR)
Unlike revenue maximization, sales maximization doesn’t take into account how much revenue is made. Instead a firm sales maximising will focus on selling as many goods/services as they can without making a loss (they will break even). This is why the breakeven point (AC=AR) is also the same as the sales maximization point.
One of the main reasons why a firm may want to operate at the point of sales maximization is to experience… Read more