The assumption that firms maximise profits

Firms are generally assumed to aim for the highest possible profits by selecting the most suitable level of output.

Conditions for adjusting output to maximise profit

• When marginal revenue exceeds marginal cost - At a given output level, if the marginal revenue (MR) from an extra unit is higher than the marginal cost (MC) of producing it, the firm should expand production. This increase adds to overall profit because the revenue gain outweighs the cost.
• When marginal revenue is below marginal cost - If MR is less than MC for the last unit produced, the firm should reduce output. This adjustment boosts profit as the cost saved is greater than the revenue lost.

The MC = MR profit-maximising rule

The optimal output level for maximising profit is reached when marginal cost equals marginal revenue.

Profit maximisation for price takers and price makers

Both price takers and price makers use the MC = MR rule to determine their profit-maximising output.

Price takers

A price taker operates in a market where it cannot influence prices, such as in perfect competition. The average revenue (AR) and marginal revenue (MR) are the same and form a horizontal line at the market price. Profit is maximised at the output where the MC curve crosses the horizontal AR = MR line.

Price makers

A price maker, such as a monopolist, can influence market prices. The average revenue (AR) curve slopes downwards, and the marginal revenue (MR) curve is steeper and also downward-sloping. Profit is maximised where the MC curve intersects the MR curve.

In both cases, the rule MC = MR identifies the output that maximises profit, regardless of the firm's ability to set prices.

The concept of supernormal profit

In the long run, a firm must generate sufficient revenue to cover all its costs, including both explicit costs (like wages and materials) and implicit opportunity costs (such as the value of the owner's time, even if no wage is drawn).

Normal and supernormal profit

• Normal profit - This occurs when total revenue exactly covers all costs, including opportunity costs, resulting in an economic profit of zero.
• Supernormal profit - Also known as abnormal profit, this is earned when total revenue exceeds all costs, including opportunity costs, leading to a positive economic profit.