Course

Profit Maximization

Instructor: Alex Tabarrok, George Mason University

Profit Maximization : The process by which firms determine the price and output quantity that will yield the highest possible profit. This is done by setting

Profit Maximization: The process by which firms determine the price and output quantity that will yield the highest possible profit. This is done by setting Marginal Revenue equal to Marginal Cost. This is from the video “Maximizing Profit Under Competition” in the Principles of Microeconomics course.

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Transcript

When the firm produces an additional unit of output, there are additional revenues and additional costs. Profit maximization is all about comparing these additional revenues and costs, and we have names for these. Marginal revenue is the addition to total revenue from selling an additional unit of output. Marginal cost is the addition to total cost from producing an additional unit of output. Profits are maximized at the level of output where marginal revenue is equal to marginal cost.


Now why is this? Well, let's suppose that marginal revenue is not equal to marginal cost and let’s show that you can't be profit maximizing if that's the case. For example, if marginal revenue is bigger than marginal cost you're not profit maximizing - producing more will add to your profit. Why? Well, remember marginal revenue is the addition to revenue from producing another unit. Marginal cost is the addition to cost from producing another unit. If marginal revenue is bigger than marginal cost, that says producing that unit adds more to your revenues than it does to your costs. In other words, you could increase profit by producing more. So, if marginal revenue is ever bigger than marginal cost, you want to produce more. On the other hand, suppose marginal revenue is less than marginal cost, or to put it the other way, suppose marginal cost is bigger than marginal revenue. Well then, you're not profit maximizing because producing less will add to your profit.


Why is this? Well, think about marginal cost. If you were to produce one unit less your costs would fall by marginal cost, your revenues would also fall by marginal Revenue, but since marginal cost is bigger than marginal revenue, your costs by producing one unit less fall by more than your revenues fall. So, if your costs are going down by more than your revenues are going down, you're again increasing profit. So, if marginal revenue is ever less than marginal cost, you want to produce less - you'll be increasing your profit by producing less. So, if marginal revenue is bigger than marginal cost, you're not profit maximizing. If marginal revenue is less than marginal cost you're not profit maximizing. You can only profit maximize if marginal revenue is equal to marginal cost.

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