Profit Maximising Theory and Firms - Coursework Example

Profit maximising Profit Maximising Theory & Firms Introduction At the elementary level, profit is understood as the excess of income over costs incurred in earning that income. For business firms, earning profits is necessary for survival and growth, and hence every firm attempts to gain maximum profits out of its operations. Economic theory explains the interplay of demand and supply vis-à-vis costs and revenues in different competitive situations. This essay deals with the issues of profits, briefly identifying how they arise, costs and prices, and the influence of market conditions / other factors on pricing decisions for profit maximisation. Profits – classical view Profit is the difference between the total revenue and total costs of a business enterprise. They also represent the earnings on invested capital over and above the market rate of borrowings. In classical view, profits are said to arise either as rewards for risk taking or due to the imperfections in the economy or as reward for innovations (Dean 1977, pp. 5 – 9). These factors are briefly explained below: Rewards for risk taking: Instead of keeping his capital in a risk-free investment like government bonds (which offer high security but minimum returns by way of interest or appreciation), an entrepreneur uses capital, both owned and borrowed, to set up a venture and offers a product or service to the market. He thus takes risks and is prepared to accept as his share of the (monetary) value of the enterprise activities, after all costs have been provided for. What is left may be losses or minimal profits or more than Profit maximising 2 reasonable profits. Imperfections in economy: According to this view, profits arise due to ‘…the imperfections in the adjustment of economy to change’ (Dean 1977, p.8). Changes occur due to competitive market conditions – supplies or suppliers increase; prices rise or fall; newer products or technologies pose challenge to the existing ones, etc. There is a time lag between the occurrence of a change and the return of the market to competitive position or equilibrium, and it is during this time of absorbing the change that profits accrue. Reward for innovation: In this third view on profits, it is stated that profits are what the entrepreneur is entitled to, for putting his business ideas into practice by organising the activities for realising the innovation. His innovation upsets the market equilibrium and continues to give him profits until the equilibrium is restored or till such time as he is able to create barriers preventing others to follow him through intellectual and other property rights, such as patents, trade marks and secret formulas. Profits – contemporary view Michael Porter views the activities of a firm as a ‘value chain’. To the seller, the net balance left in the value chain after providing for all costs of the activities, is his margin. The buyer has his own chain of activities, whose value is enhanced or reduced by the seller’s product; when it is enhanced, the buyer is willing to pay a higher price, and when it is reduced he will pay a lower price or even may change the supplier! Thus, the price commanded by a seller and consequently, the profit that he can achieve, has a direct Profit maximising 3 link to the value that the product can pass on to the buyer. This is an element of the ‘competitive advantage’ as described by Porter (Porter, 2004). Costs and revenues – total, average and marginal The two basic types of costs are the fixed costs of an enterprise, and the variable costs that happen with a change in the output volumes. Total cost (TC) equals to the sum of fixed and variable costs (for a given volume of output); average cost (AC) equals to the total cost divided by the corresponding numbers of units produced; and the marginal cost (MC) is the additional cost for producing an extra unit of the product. Total, average and marginal revenues (TR, AR, MR) can be described in a similar manner. Costs and revenues are considered for profit maximising in different market situations (Sloman, 2003, Ch. 5, 6 & 7). MR goes down with each additional unit sold. This is because firms are faced with a downward sloping demand curve and in order to sell one extra unit, the price must go down. Another reason why the MR goes down with each additional unit sold is that as the price for an extra unit goes down, all price of all previous units must also go down. MC is inversely related to marginal product (extra unit which is produced). As each extra worker is employed, marginal product increases, until the law of diminishing returns comes into play at which point, value of the marginal product decreases as each extra unit of labour is employed. Hence, marginal costs will initially go down and then climb up. When MR=MC, profits are maximised because if MR is greater than MC then profit can be gained from selling one extra unit of product. Also if MC is greater than MR, then by selling each extra unit, the firm loses money. This can be seen in the table Profit maximizing 4 below. Quantity MR MC MR-MC Profit 1 20 17 3 3 2 18 14 4 7 3 16 13 3 10 4 12 11 1 11 5 10 14 -4 7 6 6 15 -9 -2 7 2 18 -16 -18 These values can be plotted on a graph shown below: Using the graph above one can see that profits are maximised where MR=MC. As output quantity increases, MR goes down and MC first goes down with each additional unit and starts increasing after a certain point. Profit maximising 5 Market situation and pricing for profit maximising Competitive, monopoly, and oligopoly are the three basic market types, which influence pricing decisions for profit maximising. Competitive market: Large number of buyers and sellers, and free movement of people and goods (unrestricted entry and exit) characterise a competitive market. In this situation, no single buyer or a single seller is able to exert undue influence. Products and their substitutes are available in plenty. Items of common consumption like food grains, processed food, milk and beverages etc. are examples of products in a competitive market. In a competitive market, the MR equals the price of the goods. Fixed costs being fixed by definition, it is the variable cost element that comes into play with the changing volume of sales. In order to maximize profits, a firm has to find the point (in quantity of sales) at which the MR equals the MC, as shown below: Source: Mankiw NG, 2004, Principles of Economics, p.294 Profit maximising 6 Monopoly market: A dominant supplier influences the market, controlling supplies and prices and the buyers have to pay the price demanded by the supplier. Legislation action by governments ensures consumer protection against exploitation by monopolies. However, businesses are always looking to create monopoly situations, even if the gains are for a short period of time. But increase in price brings about a reduction in demand with the result that with each increase, the total sales and therefore the total revenue reduces. MR is always less than the price of the product. In order to maximise his profits, the monopolist has to identify the quantity of output where the MC & MR are equal as seen in the figure below: Source: Mankiw NG, 2004, Principles of Economics, p.322 Oligopoly market: Oligopoly exists for fast moving consumer goods. A few suppliers, offering competing and differentiated products within a narrow price band, characterise this market. Since there are only a few suppliers, any decision by one supplier (to increase / decrease production or prices) affects the entire market and impacts Profit maximising 7 the other suppliers as well. The few suppliers collude to decide the production volumes and prices. “When firms in an oligopoly individually choose production to maximise profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price...(Mankiw, 2004, p.352).” The oil cartel represented by the Organization of Petroleum Exporting Countries (OPEC) is an example of an oligopoly cartel. In cases where such collusion is not possible due to antitrust laws or for any other reason, then profit maximisation is difficult to achieve with each player constantly trying to improve his market share by product differentiation, pricing and promotion. Profits under these circumstances approach those that can be expected under competitive market conditions. Conclusion: Profit maximisation is the aim of all businesses. The subject of ‘Business Economics’ helps one to appreciate the interplay of the internal and external environment of a firm, and to plan for profit maximisation under different market conditions. Efficiency of operations decides the costs and revenues. Market conditions decide the prices, sales volumes and hence the total revenues. Internal situation analysis would focus upon product features and costs. Costs in turn are incurred on factors of production viz., land, labor and materials. External situation analysis would focus on the customers and the competitors, collectively called the market. Depending upon whether the firm is operating in a competitive market or an oligopoly market or in a monopoly market, the levels of investment on the factors of production and the planned output will be Profit maximising 8 determined. Market dynamics as discussed in the foregoing paragraphs help to decide the pricing strategy for profit maximisation. References Dean J, 1977, Managerial economics, Prentice Hall, New Delhi. Dept. of economics, finance and international business (2005), Module booklet EC1002CN, Introduction to microeconomics, London Metropolitan University. Mankiw NG, 2004, Principles of economics, South-Western Educational Publishing. Porter ME, 2004, Competitive advantage, Free Press, New York. Sloman J, Economics, Prentice Hall, New York. Customer draft! Economists believe firms aim to maximise profits. Firms adjust price and output to achieve the greatest profits. It is assumed all firms want to maximise profit even a charity supporting children with aids, will try to maximise profit as they want to get the most amount of money to support the children. Specialists are hired to help manage costs and cash flows. If these measures weren’t taken the firms wouldn’t be maximising profits, so in the case of the charity they would be unable to support these children in the manner in which they do currently. In order to maximise profits firms will produce to the point where MR=MC. MR stands for marginal revenue this is the amount of money gained from each additional unit sold. MR goes down with each additional unit sold this is because firms are faced with a downward sloping demand curve so to sell one extra unit the price must go down. Another reason why the MR goes down with each additional unit sold is that as the price for an extra unit goes down all previous units must also go down in price. MC stands for marginal cost this is the cost incurred from each additional unit of production. Marginal costs are inversely related to marginal product, when marginal product rises marginal product falls. As each extra worker is employed marginal product increase until a point where the law of diminishing returns comes in at which point marginal product decreases as each extra unit of labour is employed. So marginal costs will initially go down then back up. When MR=MC profits are maximised because if MR is greater than MC then profit can be gained from selling one extra unit of labour. Also if MC is greater than MR than by selling each extra unit of labour you lose money. This can be seen in the table below. QUANTITY MR MC MR-MC PROFIT 1 20 17 3 3 2 18 14 4 7 3 16 13 3 10 4 12 11 1 11 5 10 14 -4 7 6 6 15 -9 -2 7 2 18 -16 -18 Using the graph above we can see that profit are maximised where MR=MC. We can now clearly see that as quantity increases MR goes down and MC first goes down with each additional unit but than starts increasing after a certain point. Read More