What is Profit Maximisation?
An enterprise manufactures and sells a definite amount of a commodity. The enterprise’s profit, which is denoted by π, is defined as the difference between its TR (total revenue) and its TC (total cost of production). In other words, π = TR – TC
The gap between TR and TC is the enterprise’s income net of costs. An enterprise wishes to maximise its profit. The enterprise would like to recognise the amount or quantity q0at which its profits are utmost. By definition, at any quantity other than q0, the enterprise’s profits are less than at q0. The question is: how do we recognise q0? For profits to be maximum, 3 conditions must hold at q0:
- The cost price – p, must be equal to MC
- Marginal cost must be non-decreasing at q0
- For the enterprise to continue to manufacture, in the short run, cost price must be greater than the average variable cost (p > AVC); in the long run, cost price must be greater than the average cost (p > AC)
Profits are nothing but the difference between total revenue and total cost. Both TR and TC goes up as output goes up. As long as the change in total revenue is greater than the change in total cost, profits will continue to rise. Recall that change in TR per unit increase in output is the marginal revenue; and the change in total cost per unit increase in output is the marginal cost.
Now, let us consider the 2nd condition that must hold good when the profit-maximising output degree is positive. Note that at output degrees q1 and q4 , the market price is equivalent to the marginal cost. However, at the output level q1 , the marginal cost curve is downward graph. We claim that q1 cannot be a profit-maximising output degree.
Let us consider the 3rd condition that must hold good when the profit maximising output degree is positive. Notice that the 3rd condition has 2 parts : one part is applicable in the short run while the other applies in the long run.