Calculating profit and reasons for profit maximisation

Profit represents the financial gain a firm makes after covering all its expenses. It is a key objective for many businesses, providing the resources needed for sustainability and growth.

Formula for calculating profit

$\text{Profit}=\text{total revenue}-\text{total costs}$

Where:

• Total revenue = All money received by the firm, such as from sales of goods or services (£)
• Total costs = All expenses incurred by the firm, including both fixed and variable costs (£)

Reasons why firms aim to maximise profit

• Ensuring survival - Profits allow a firm to continue operating, as consistent losses can force closure.
• Rewarding stakeholders - Higher profits enable better payments to owners, shareholders, or employees, improving motivation and retention.
• Reinvestment opportunities - Profits can be used to fund improvements, such as new equipment or technology, with the aim of generating even greater returns in the future.
• Facilitating expansion - Accumulated profits support growth, like opening new locations or entering new markets.

Alternative business objectives

While profit maximisation is common, some firms prioritise other goals that align with their values, market position, or long-term strategy. These alternatives can sometimes conflict with short-term profit but may offer other benefits.

Other objectives firms may pursue

• Maximising sales or market share:
  • Increasing market share can create monopoly power, allowing the firm to set higher prices due to reduced competition.
  • Larger firms often gain prestige and stability, making it easier to attract top talent.
• Ethical or social goals:
  • Firms may focus on 'doing good', such as supporting communities, even if it reduces profits.
  • For example, a business might buy materials from local suppliers to boost the local economy, despite cheaper options being available abroad.

Normal profit and shutdown decisions in the short run and long run

Normal profit is the minimum level of profit required for a firm to continue operating in the long run, as it covers all costs, including the opportunity cost of using resources elsewhere. Shutdown decisions depend on whether a firm can cover its costs, with different considerations in the short run and long run.

Normal profit

Normal profit occurs when total revenue exactly covers all costs, including the value of alternative uses for the firm's resources. If a firm fails to achieve this, it will eventually close, as its factors of production (like labour or capital) could generate better returns in other activities.

Shutdown decisions in the short run

In the short run, firms face fixed costs that must be paid regardless of output:

• Continue operating - If total revenue exceeds total variable costs (or average revenue exceeds average variable costs), the firm should keep producing. The excess revenue helps pay some fixed costs, reducing overall losses compared to shutting down.
• Shut down immediately - If total revenue is less than total variable costs (or average revenue is less than average variable costs), the firm should stop production at once, as it cannot even cover its variable expenses.

Loss-making firms may not shut down immediately if they can partially cover these costs.

Shutdown decisions in the long run

In the long run, all costs become variable, and fixed costs can be avoided by exiting the market:

• Firms will shut down if they cannot achieve normal profit, as ongoing losses are unsustainable.
• If the market price is below the level where normal profit is made (P), the firm should exit.
• If the price is between P and a lower point (P_L), where variable costs are covered, the firm may continue in the short run but must reassess for the long term.
• If the price drops below P_L, immediate closure is necessary, even in the short run, as variable costs are not covered.

The profit maximisation rule using marginal cost and revenue

Firms aiming to maximise profit must determine the optimal output level.

The MC = MR rule

Profit is maximised at the output level where marginal cost equals marginal revenue.

$\text{MC}=\text{MR}$

Where:

• MC = Marginal cost: the additional cost of producing one more unit (£)
• MR = Marginal revenue: the additional revenue from selling one more unit (£)

This rule applies to both price takers (firms that accept market prices) and price makers (firms that set their own prices).

Reasons for adjusting output based on MC and MR

• If MR > MC - The firm should increase output, as the revenue from the extra unit exceeds its cost, adding to overall profit.
• If MR < MC - The firm should reduce output, as the cost of the last unit exceeds its revenue, and cutting back would increase profit.
• At MC = MR - No further changes are beneficial; this is the profit-maximising point.