Profit Maximization of a Firm

Profit maximization has always been considered the primary goal of firms.The firm’s owner is the manager of the firm, and thus, the firm’s owner-manager is assumed to maximize the firm’s short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money. In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm. The expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period.

A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm produces beyond this point of equality between the marginal revenue and marginal cost, the marginal cost will be higher than the marginal revenue. In other words, the addition to total production beyond the point where marginal revenue equals marginal cost, leads to lower, not higher, profits. While every firm’s primary motive is to maximize profits, its output decision (consistent with the profit maximizing objective), depends on the structure of the market it is operating under.

As mentioned earlier, firms’ profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly.

Perfect Competition

Perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. For a market structure to be deemed “Perfectly Competitive”, it needs to have the following characteristics:

1) Many Buyers and sellers, but none of which are large enough to influence the price of a product in the market.

2) Each firm produces a homogeneous product; that is the products are indistinguishable from the other firm’s product in the same market.

3) Firms have little or no restrictions towards entering or exiting the market, thus increasing competition

4) Buyers and sellers have all the necessary information to run a business effectively, such as product prices, quality, source of supply etc.

A firm that is perfectly competitive is also known as a price taker, which means that the seller does not the ability to control the price of a product it sells but are rather determined by the market.

Perfect Competition in the Short-Run In perfect competition, a firm’s demand curve perfectly elastic or horizontal.

In the short run, it possible for a firm to make a profit. This is because the Average Revenue which is denoted by P is higher than the point C which denotes the Average Cost.

Perfect Competition in the Long-Run

In the long run, Marginal Cost (MC) =Marginal Revenue (MR). So the firms cannot achieve profit. One of the reasons is because other investors see the opportunity to earn profit by investing, so the market share and profit of the older firms falls as the demand curve shifts downwards. When MR=MC, a firm does not have a profit nor incur a loss.

Monopolistic competition Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another. Examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. Monopolistically competitive markets have the following characteristics: * There are many producers and many consumers in the market, and no business has total control over the market price. * Consumers perceive that there are non-price differences among the competitors’ products. * There are few barriers to entry and exit. * Producers have a degree of control over price.

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm’s marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit.

Oligopoly In an oligopolistic competition only a few competitors (three, four or five) exist since it is often difficult to enter such markets due to 1 the lack availability of required raw materials 2 the restriction to access the needed technology 3 shortages of funds 4 the firms simply got patent rights Examples of oligopolies may include the markets for petrol in the UK (BP, Shell and a few other firms) and soft drinks (such as Coke, Pepsi, and Cadbury-Schweppes), the “Big Three” in the U.S. aluminum industry and companies such as Nokia or Motorola in the cell phone industry, as well as companies in the video game console market. Read also which helps enable an oligopoly to form within a market?

In an oligopoly it is generally assumed that the four largest firms in the market occupy greater than 40% of the market share. Naturally in such markets price changes do not occur often. The firms are interdependent on each other as slight increase in selling price of one firm will result in gains for other firms as the lost customers will switch to other firms. At the same time a slash in price will lead to other firms reducing their prices as well. Hence we may assume that in an oligopolistic market the firms practice economies of scale to begin with, that is they produce at maximum efficiency. Nonetheless these companies may also increase their selling prices on a mutual basis so as to churn out maximum amount of profits from the consumers.

An example could be from the following kinked demand graph:

Monopoly: Monopoly is the theory of market structure based on three assumptions: There is one seller, it sells a product for which no close substitutes exist, and there are extremely high barriers to entry. Local electricity companies provide an example of a monopolist.

There are many factors that give rise to a monopoly. Patents can give rise to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly, however, can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by the appropriate government agency. Finally, a monopoly may arise due to declining cost of production for a particular product. In such a case the average cost of production keeps falling and reaches a minimum at an output level that is sufficient to satisfy the entire market.

At any output level, the price charged by a monopolist is higher than the marginal revenue (MR). As a result, a monopolist also does not produce to the point where price equals marginal cost (MC). If marginal revenue is greater than marginal cost, as is the case for small quantities of output, then the firm can increase profit by increasing production. Extra production adds more to revenue than to cost, so profit increases. If marginal revenue is less than marginal cost, as is the case for large quantities of output, then the firm can increase profit by decreasing production. Reducing production reduces revenue less than it reduces cost, so profit increases.If marginal revenue is equal to marginal cost, then the firm cannot increase profit by producing more or less output. Profit is maximized.