Profit Maximization Theories Applicable to Firms - Term Paper Example

Profit Maximization Theories Applicable to Firms. Introduction Micro economics is the analysis based on micro units represented by the firm, consumers amongst others, and profit maximization as a function of the firm, can occur both in the short and long run and in the process, the firm determines price and output levels that provides the highest profit. There are several profit maximization theories that are applicable to firms. In understanding profit maximization, the theory of the firm comes to play. Theory of the Firm Firms must act to maximize their profits, and this is the basic tenet of the theory. Profit is defined as the difference between the total cost and the total cost Hall and (Marc, 197). In accounting a negative difference implies a loss, whereas a positive one implies a profit. Mathematically, calculating profit shall be: Π = TR – TC Π, rho which is conventionally used to represent profit mathematically, TR is the total revenue and TC is the total cost. Total revenue is the total value expected and received by a firm from the sales of its goods and services. Total revenue on the other consists of all factors of production and other operational considerations. In economics, there are other types of costs that come into play, for instance, opportunity cost, and not specifically those costs that involve explicit monetary payments. The accounting profit implies the monetary values reported in the books, whereas the economic profit includes other factors such as the non quantifiable opportunity costs, implicit and explicit resources employed. Firms face certain constrains in the process of maximizing their profits. The main constraints face by profit maximizing firms include: technology, prices of factors of production and the demand for a firms product. According to Hall and Marc (201), a firm’s total revenue is the total inflow of receipts from selling output. Types of Firms Theoretically firms can be grouped from two extremes; perfectly competitive firm and monopoly, each facing different demand curves. The concept of demand is closely related to the understanding of profit maximization. A perfectly competitive firm has a horizontal demand curve implying high elasticity. A monopolist demand curve on the other hand faces the whole market demand curve, which is highly inelastic. Understanding the concept of profit maximization, graphical and mathematical analysis becomes imperative. If an assumption of perfect market is made for a profit maximization firm. Total and marginal Revenue Total revenue is total number of quantities multiplied by the unit price. Mathematically, this is represented by, TR = pq, Where p is the unit price for each product from the organization and q is the total number of quantities sold by the firm. Conventionally, small q are used instead of the capitalized version, Q as it is used to imply the whole market. Given a downward slopping demand curve Price a b y x Quantity Figure 1 showing a negative slopping demand showing price as function of quantity. From figure 1, an increase in quantity from y to x would be necessitated by a fall in price from a to b, nut still this does not explain profit maximization, but it is a step towards such an explanation. The price a to the quantity y and the corresponding rectangle given by area bounded by b to point 0 to x and the intercept on the demand curve is the TR. Marginal Revenue is the change in total revenue as a result of an increase in quantity by a unit. Mathematically, MR= ∆TR/∆q. Since quantity moves by a unit, and at that level, MR is equal to price. In economics, the marginal revenue curve is always below the demand curve. This means that at any quantity, the demand curve informs the price to quantity. In addition, the MR curve meet in demand curve at the vertical point where they cross. A lower price has the effect of people buy more quantities and people pay fewer units. The demand curve predicts the MR; an elastic demand implies a positive MR, which is above the horizontal axis, a unit elastic demand implies an MR which is equal to zero, and finally an inelastic demand implies an MR which is less than zero. A straight line demand curve implies an MR that has a slope twice that of the demand curve and that it intersects the horizontal axis at the midpoint between the origin and the point where the demand intersects the axis. This is because unlike the nonlinear demand curve, the linear demand curve is unit elastic midpoint down the length; hence, the MR intersects the horizontal axis at the quantity, midpoint on the demand curve The Build Up Marginal revenue and marginal cost are applied to analyse profit maximization. Just like marginal revenue, marginal cost implies the extra cost as a result of an extra unit of quantity. Increasing output by a single unit brings more revenues than costs to produce such units. Mathematically, MR > MC, therefore, to produce the single unit and this will add more benefit compared to the added cost. Conversely, if the last unit cost more to produce more than additional revenue and that is MR< MC. Therefore it is important to reduce production as the extra unit reduces profit as a result of the assed cost than added benefit. At the point where MR = MC, this is the general rule for profit maximizing firm, and it applies to a firm irrespective of competition, whether perfect competition or even monopoly. TC and TR theorem Total cost is the total of variable costs and the fixed costs, but these sub components are not used in the analysis of profit maximization, rather merely costs analysis. The profit maximizing output, then initially TR = TC. The profit maximizing output is the one that attains the maximum difference between the two. In the short term, MR = MC, but in the long term MR > MC and the firms make supernormal profit. According to Hall and Marc (2013), a firm should aim to maximize its profit and not its profit. Profit is the difference of the cost and revenue, but the latter is the multiplication of price and quantity, shown by figure1. Price MC P* q * MR D Figure 2 showing a relationship between price and quantity and demand, marginal cost and marginal revenue curves. At Quantity, q* MR and NC curves intersects, and by extending the point to the intersection till the demand curve, we find the corresponding price, represented by p*. A price above the price p* will lower the quantity sold, q < q*, on the other hand a lower one below the price p* will increase sales above q*, q > q*. To determine profit for a firm, incorporation of the costs become imperative, particularly the ATC, the average total cost and marginal cost, but ATC = TC/Q, graphically when price is plotted against quantity, the ATC becomes a concave curve. Price ATC ATC* q * Quantity Figure 3 is a ATC curve. Profit is the difference of TR and TC, and it is p*q*, whereas TC is ATC*q*, hence a difference in the areas, graphically represent the profit. Price MC ATC P* A ATC* q* MR D Quantity Figure 4 a diagram showing the profit rectangle The firm is making profit as the price, p* is higher than the ATC, and for a negative profit, accountants refer to it as a loss, as it is gotten when the ATC is less than the price, p*. Perfect competition For a perfectly competitive firm, the first step towards profit maximization is to set MR = MC. This means that MR = p* and the firm sets p* = MC. If he price of a unit is in excess of the cost of producing the unit, then production of the unit should be carried out. Price MC P* MR q* quantity Figure 5 showing a perfect competitive firm showing demand/MR and MC curves. Much in the general theory, ATC is used to develop profit maximization theory. Price MC ATC P * MR B q* Quantity Figure 6 showing MR, MC and ATC curves showing and B is the rectangle representing profit for this firm. Conclusion The theory of the firm is the basis upon which the analysis of profit maximization is based upon. Firms can range from monopoly to perfect competition and the difference is represented in their demand curves. An average total cost entails the average variable and the average fixed cost. Suggested area of further Research Theories of the firm with respect to profit maximization are limited to a certain degree. The analysis of profit maximization with respect to monopolistic firms and duopolies often result in inconclusive answers. Works Cited Hall, Robert E, and Marc Lieberman. Microeconomics: Principles and Applications. Mason, OH: Thomson/South-Western, 2005. Print. Read More