Profit Maximization

Updated on April 12, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Profit Maximization?

Profit maximization refers to a tendency of business firms to maximize profits in the short or long run by using the most efficient methods and equalizing the marginal cost and revenues. Its main purpose is to increase the level of production of a firm or business that will grant it the maximum profit on selling goods and services.

What Is Profit Maximization

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It has been the major objective of every business and enterprise. It makes profit maximization outputa pillar of conventional theories of economics. Many of its assumptions have helped economic theorists formulate multiple theories related to prices and manufacturing. In addition, it aids in being well-versed with the business behavior and the effect of price, input, and output in various market situations.

Key Takeaways

  • Profit maximization means increasing profits by the business firms using a proper strategy to equal marginal revenue and marginal cost. This theory forms the basis of many economic theories.
  • It is present in a monopoly and perfect competition market.
  • The profit maximization formula depends on profit = Total revenue – Total cost. Therefore, a firm maximizes profit when MR = MC, which is the first order, and the second order depends on the first order.
  • This concept differs from wealth maximization in terms of duration for earning profit and the firm’s goals.

Profit Maximization Explained

Profit maximization is a strategy of maximizing profits with lower expenditure, whereby a firm tries to equalize the marginal cost with the marginal revenue derived from producing goods and services. Economists Hall and Hitch’s theory says that every firm’s sole moto should be to generate profits. Classical economists assume the same.

It is the prime target of every firm and is necessary for their progress. Companies can maximize profits by increasing the price or reducing the production cost of the goods. Firms adjust influential factors like selling price, production cost, and output levels to realize their profit goals.

Theoretically, the point at which the marginal cost and marginal revenue become equal allows for the maximum gap between the MR and MC. As a result, the profit at this point is always maximum.

However, if the management decides to use sub-standard raw materials for production due to the profit maximization calculator indicating them to lower their production costs, their customer base could have adverse effects. Therefore, drawing a fine line between profit maximization and quality management is a critical aspect of the process.

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Graph

Profit maximization output is derived taking many aspects into consideration. Initially, the profit becomes equal to the cost subtracted by revenue which can be plotted graphically. Then, the graph can be constructed using the revenue and cost as variables plotted against the function of output, as shown below in the supply and demand graph:

Profit Maximization Graph

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  • One of the major conditions to maximize profits is that the marginal revenue and marginal cost must be equal (MC = MR). It is the equilibrium point on the graph. Producers or firms achieve equilibrium when there is the widest gap (maximum difference) between MR and MC; and TR and TC.
  • In the above graph, Q1 (output) is the point that intersects MR and MC. The above graph shows that if the firm produces less output than equilibrium quantity Q1, then MR becomes greater than MC. As a result, the firm is gaining more revenue than the cost it is spending on producing goods, leading to an overall enhancement of profit.
  • As the output by the firm approaches the level of Q1, initially, the MR is slightly greater than MC.
  • Subsequently, as the output crosses Q1, the marginal cost will substantially increase over the marginal revenue. As a result, the firm will experience a revenue loss.

Therefore, the firm can maximize profits only at the point of Q1.  It begins to fall after crossing point Q1 as MC > MR.

Formula

As every firm desire to maximize its profits, its total profit is measured by the difference in the total revenue and total cost of production of goods. The total cost of production (TC) is a firm’s expenditure to produce goods and services. Marginal cost is the cost of selling one additional unit. Total revenue is the income that a firm generates after the sale of its products and services. Marginal revenue is the revenue that it generates from selling one additional unit. Let us first understand the formula to use a profit maximization calculator which shall act as a basis to understand all related concepts.

Hence, the simple formula of total profit is P = total revenue (TR) – total cost (TC);

Or, P= TR-TC

Thus, the profit is maximum when the difference between revenue and cost is the maximum.

However, it happens under two conditions – first order and second order.

First-order

It mandates that input’s marginal cost (MC) equals marginal revenue (MR). mathematically: MR = MC

Second-order

According to it, one must fulfill the first order if the marginal revenue decreases and the marginal cost increases. In other words, when marginal cost & marginal revenue are plotted on a graph against the output, the slope of marginal revenue must always be less than that of the slope of marginal cost for the application of second-order profit maximization.

Monopoly

The profit maximization output for monopoly depends upon PM pricing and profit-maximizing quantity or level of output. It means that the marginal revenue decreases with an increase in the production of goods by an extra amount. MC > MR if the firm produces a higher quantity. In monopoly, the curve of marginal cost is upward sloping. Hence as per the profit maximization rule, the best option for profit maximization for monopoly is to produce that quantity of goods which makes the marginal cost equal to marginal revenue. That is, MR = MC.

Profit Maximization in Monopoly

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Moreover, it can make higher profits if MR > MC if firms choose to lower the quantity of their output. As a result, the firm in the monopoly makes a greater profit by expanding the output quantity and charging a higher price than a competitive market. Furthermore, a monopoly firm can maximize profits by decreasing the production level if the marginal revenue becomes less for the firm when it produces many goods.

Perfect Competition

In perfect competition, many producers create and sell homogenous goods and services in the market. Here the buyers have perfect information about the market. As a result, firms cannot influence the price of the goods and services, so they are the price taker.

As demand is perfectly elastic, D = MR (Marginal Revenue} = AR (Average Revenue). So, the objective of these firms is to choose an output level to maximize profits. Hence, the sole determinant of the for-profit maximizer is point P. At point P, the revenue received on selling the only left product equals that of the marginal cost involved in producing the one final product.

Profit Maximization in Perfect Competition

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The efficient use of profit maximization calculator in perfect competition, the point where marginal cost and the price becomes the same makes it possible for the condition of maximum profit to satisfy the corresponding demand curve. As a result, marginal revenue decreases in value than the marginal cost. It leads to the need to produce more goods by the firm. Therefore, the firm observes a decrease in its profit in the process.

Hence, in the short term, in the graph of this concept, P becomes the equilibrium point making marginal revenue equal to marginal cost. Again, as a result, the firm under perfect competition must manufacture goods equivalent to P to maximize its profit.

Here too, profit is maximum when marginal revenue = marginal cost (MR = MC)

Advantages

Let us understand the process of adopting measures to bring out profit maximization outputs through the discussion below.

  • Profits are an efficient metric to gauge the growth of the business and can ascertain the viability of the business model.
  • A dip in profits can be easily identified and rectifications can be made accordingly in a timely manner.
  • On a macro level, it helps with social and economic welfare as profits from the business could be put forth towards building infrastructure, on employee welfare, and other such investments.
  • It ensures that the increased efforts of employees within the organization leads to an increase in net revenue for the business.

Disadvantages

Despite the various advantages mentioned above, there are a few factors that create uncertainty and confusion around using a profit maximization calculator. Let us understand the disadvantages through the discussion below.

  • The “profit” aspect of this concept is unclear to a large extent. In accounting, profits can be gross profit, net profit, profit rate, or even profit before tax, and after tax.
  • The risk involved in the process is completely negated. Since risk in any business affects its survival to some extent, it becomes important to hedge risks in the process of maximizing profits which the definition and process conveniently discount.
  • The process of profit maximization is a series of steps that can take a considerable amount of time. Therefore, the present value of money will not necessarily have the same value in the future as well which this concept does not consider.
  • The quality of products, services, and other such intangible factors in the business are not considered despite the fact that it directly affects the credibility and longevity of the business.

Profit Maximization vs Wealth Maximization

Although both the terms – profit and wealth maximization relate to the profit-making perspective of a firm, both are different in many aspects. Here are some points to clarify these concepts: The basic difference between them is the goal and duration of profit earnings. Let us understand their differences through the comparison below.

  • Profit maximization output focuses on short-duration profit earnings that may eventually be detrimental. In contrast, wealth maximization is a long-term approach for making the shares of the firm gain more value and increase the stakeholders’ wealth.
  • The former does not require any promotional activity by the management, whereas the latter employs marketing, research, and product updates to attain its goal.
  • For the former, management usually undertakes expenditure cutting to decrease risk profile, whereas, in the latter, management focuses especially on risk mitigation goals for risk reduction.
  • In the former, the increase in the spending on production capacity is less. However, at the same time, wealth maximization requires heavy expenditure on increasing production capacity to accomplish a firm’s long-term sustainable profit-making goal.

Frequently Asked Questions (FAQs)

What is profit maximization in financial management?

Profit maximization in financial management means the objective of a firm to take all financial decisions to maximize the profit of a business concerning its investments and savings.  It also acts as a key parameter in measuring the performance and efficiency of a firm economically.

What is the profit maximization rule?

The common rule for profit maximization is that firms should be able to produce enough goods and services to increase the marginal revenue. The marginal revenue should equal the marginal cost of goods and services. Therefore, the output amount of goods should be such that the price (P) charged to the customers valuing the product should equal the marginal cost (MC) that the society uses to produce one unit or product, i.e., P = MC.

What is profit maximization in economics?

In economics, profit maximization occurs when there is a maximum gap between total revenue (TR) and the total cost (TC). In other words, it happens when the marginal revenue of production is equal to or more than its marginal cost. (MR = MC).

How to achieve profit maximization?

Firms, businesses, and institutions can maximize profit by increasing sales revenue and cutting production costs.

This has been a guide to what is Profit Maximization. Here we explain its effect on monopoly & perfect competition, its formula, and its advantages. You may learn more about financing from the following articles –