Essay on "Profit Maximization Theory Profit Is the Ultimate"

Essay 5 pages (1367 words) Sources: 1+

[EXCERPT] . . . .

Profit Maximization Theory

Profit is the ultimate goal of every firm. In fact, every firm operates to generate a reasonable amount of profit. Profit is the difference between the total revenue obtained by the firm and the total costs incurred by it. This drives the firm to produce more and more goods or services. On the other hand, every item that is produced must be consumed to generate profit. In general, it is assumed that firms produce and households consume and the difference between the cost of production and the revenue generated by the consumption is profit.

Profit maximization theory has been further explained by McCann & Vroom (2009, p.2) as, "The assumption of profit maximization as the goal of the firm in strategic management flows naturally from the close connection between strategy and economics. In standard economic theory, resources may either be consumed by individuals or used by firms in production. Consumption takes place in the household while production takes place within the firm. Households derive utility from consumption, so household decisions are driven by utility maximization. In contrast, firms do not derive utility directly from production, so firm decisions are driven by profit maximization."

Computation of Profit Maximization

In general, profit maximization is computed as the difference between revenue and costs. So,

Profit = Total Revenue -- Total Cost.

But, while computing profit maximization, one must compute it using marginal revenue and marginal cost to get a more accurate picture. Marginal revenue is the revenue that is obtained by selling one more additional unit of a product. It is the extra money that one extra item of the same product will bring to the firm. On the other hand, marginal cost is the cost incurred by a company to increase production by one unit. In other words, marginal cost is the cost of producing one more extra item. True profit is the difference between marginal revenue and marginal cost because a firm attains price equilibrium when marginal cost is equal to marginal revenue. Therefore,

Profit = Marginal Revenue -- Marginal Cost

If the marginal revenue is less than the marginal cost, then it results in a loss to the firm. This equation can also be used to determine if a company should increase or decrease its production to gain maximum profits. If the marginal revenue is greater than the marginal cost, then it means every extra unit is bringing more profits for the firm. Therefore, the firm must increase its production to maximize its profit. On the other hand, if the marginal cost is more than the marginal revenue, then it means that the firm is spending more money for every extra unit produced and this cost does not translate into higher profits for the firm. So, in this case, the firm must lower its production to gain maximum profits.

This can be explained with the help of a diagram. In the diagram below, cost is on the y-axis while quantity is on the x-axis. ATC is the average total cost of all the units produced while AVC is the average variable cost curve for the same quantity of units produced. AFC is the average fixed costs incurred by the firm to produce a certain number of units. ATC is calculated as the total cost, i.e., fixed and variable costs, divided by the total quantity produced. AVC is calculated as the total variable cost of the firm divided by the total quantity while AFC is the total fixed costs of the firm divided by the quantity. Variable costs include labor, electricity, power and so on and these costs will increase as the firm increases its production. On the other hand, fixed costs are rent, administrative expenses and so on and these costs will decrease as the firm increases its production. This is because the cost remains the same month after month and when productivity is increased, the average cost reduces.

Therefore, in the diagram, AFC decreases as quantity increases while AVC increases as the quantity increases. In fact, it is a perfectly upward sloping curve that has a one-on-one correlation with… READ MORE

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