What is the main motive of a firm?

Why do we assume firms are profit maximisers?

As an investor, you take a risk when investing in a company and so you expect a financial return.

From the profit equation, what condition allows
firms to maximise profits?

Profit = Total Revenue – Total costs

For a firm to make profit:
Revenue > Costs

BUT in order to find the degree to which profits are greater
than costs, economists need to understand both:

1. The output level at which profits are maximized and
2. The amount of profit generated at the maximum

The way we do that is by looking at…

Average and Marginal Revenue

Average Revenue is the average price charged by the firm

Marginal Revenue is the change in revenue from selling one more unit.

Profit Maximization

Profit Maximization is the Output Level at which the firm generates the Highest Profit

For a firm this is where:
Marginal Revenue = Marginal Cost

Marginal Revenue, Marginal Cost band Profit Maximization

Profit Maximization

It is important that MC and profit maximization are not policy prescriptions for Economists not saying firms must behave in this way.

Rather, economists have said profit maximization is a reasonable assumption to hold about the behaviour of firms; and if we do model firms as profit maximisers,  then output must be at the point where MC = MR.

Business Problem: Making Profits

Market Structures

Perfect Competition and the Firm’s Average
and Marginal Revenue

Short Run:
Perfect Competition and Profit Maximization

Step 1: The firm maximizes profits by producing the profit maximizing level of output associated with MC = MR.

Step 2: What does it cost to produce the profit maximizing output? Simply draw the line up from the profit maximizing output until it touches the short run average total cost curve, SATC. So, in this case, £8 per unit.

Step 3: What revenue will the firm earn by selling the profit maximizing output? Simply draw the line up from the profit maximizing output until it touches the average revenue line, AR. So, in this case, £10.

Step 4: Profit per unit is AR minus AC, so £10 − £8 or £2 per unit.

Step 5: Total profit is profit per unit times the number of units produced. Or, in our figure, the rectangle defined by AR − AC and the profit maximizing output.

Accounting and Economic Profits

Normal and Supernormal Profits

Short Run:
Perfect Competition and Profit Maximization

Long run (1)

Long run (2)

Efficiency

Changes in Market Demand and
Adjustment to Long Run Equilibrium

Changes in Market Demand and
Adjustment to Long Run Equilibrium

Market Structures

Monopoly:

Average and Marginal Revenues

Monopoly:

Profit Maximization

Creative Destruction

Creative destruction occurs when a new entrant outcompetes  incumbent companies by virtue of being innovative
– However, under this approach, monopolies generally raise prices, restrict  output and earn supernormal profits.
– Rent seeking behaviour is the pursuit of supernormal profits. An  economic rent is a payment in excess of the minimum price at which a good or service will be supplied.

Comparison of Perfect Competition and Monopoly

Monopoly, is it?

A durable good is one in which consumption is ongoing, for example, a appliances.

A perishable good is one which either decays: for example, fruit and vegetables, or is consumed quickly: for example, wine, Coca Cola.

Business Application:
Wrong and Right Box

Business Application:
Porter’s Five Forces