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Profit maximisation

Profit maximisation refers to the goal of a company to earn the highest level of profit possible. It's about maximising the difference between total revenue and total cost.

In economics, the concept of profit maximisation assumes that a company has perfect information and can make rational decisions to increase profits. This can be achieved through strategies such as increasing sales, reducing costs, or expanding market share.

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Profit maximisation

Occurs when marginal revenue = marginal cost
Marginal revenue (MR) is the change in total revenue from selling an extra unit
Marginal cost (MC) is the change in total cost from producing an extra unit

If MR>MC, then selling an extra unit will add to profit
If MR<MC, then selling an extra unit will lower profit

MR = MC

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Diagram to show profit

We need to consider the average revenue (demand), marginal revenue, average total cost, and the marginal cost.

As mentioned, the profit maximising output for a firm will be when MC = MR.

When drawing the diagrams, draw in the following order:

AR
MR
AC (U shape) - draw the minimum somewhere between the AR and MR curves)
MC (cutting the AC at its minimum)

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

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PROFIT MAXIMISATION

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

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PROFIT MAXIMISATION

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

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PROFIT MAXIMISATION

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

AC1

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PROFIT MAXIMISATION

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

AC1

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PROFIT MAXIMISATION

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PROFIT MAXIMISATION AS AN OBJECTIVE

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

AC1

Total profit is green shaded area

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PROFIT MAXIMISATION

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Break even points

Price, Cost

Output

Average Revenue

Average Cost

Marginal Cost

Marginal Revenue

Break-even output

AC1

Total profit is green shaded area

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PROFIT MAXIMISATION

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Normal profits

Normal profit is a concept used in economic theory to describe the level of profit earned by a company or industry that is sufficient to keep it operating, but not so high that it would attract new firms into the industry.

In economics, normal profits refer to the level of profit that allows a firm to cover all its explicit and implicit costs, including the opportunity cost of the resources it employs.

Normal profits represent the minimum level of profit needed to keep a business operating in the long run.

AR = AC

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Normal profits - explicit and implicit costs

Total revenue is the total income generated from sales.

Total Explicit Costs are the actual operating expenses for a business, such as wages, rent, materials, energy and other direct costs.

Total Implicit Costs include the opportunity cost of using the owner's or investors' resources in the business.

This includes the return they could have earned in their next best alternative.

This implicit cost is assumed to be included in a firm’s calculation of AC.

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OUTPUT WHERE NORMAL PROFITS ARE MADE

Output

Profit Max: MC=MR

Output where AR=AC

At this output, normal profits are made

Cost & Revenue

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PROFITS

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OUTPUT WHERE NORMAL PROFITS ARE MADE

Output

Profit Max: MC=MR

Output where AR=AC

At this output, normal profits are made

Cost & Revenue

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PROFITS

For example, a highly competitive industry with low barriers to entry (think: retail or food service) is likely to have a lower normal profit than a less competitive industry with high barriers to entry (think: aerospace or pharmaceuticals).

Normal profit is highly dependent on the specific industry and the competitive landscape.

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Why are normal profits important?

If a company is earning below-normal profits for a sustained period, it may be a sign that the industry is not profitable enough to justify continued capital investment, which could lead to some firms exiting the industry.

In publicly traded companies, shareholders are often focused on maximizing their returns, and they expect the company to earn profits that exceed the normal profit level. This can put pressure on management (agents) to pursue strategies to increase profits, such as mergers and acquisitions, cost cutting, or expansion into new markets.

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Why are normal profits important?

On the flip side, a company that is consistently only earning normal profits may be viewed as underperforming by shareholders, which can lead to a decline in the company's stock price and make it vulnerable to a takeover.

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Supernormal profits

In economics, supernormal profit, also known as economic profit or abnormal profit, refers to a level of profit above and beyond what is needed to cover all its costs, including the opportunity cost of resources.

In other words, supernormal profit represents a situation where a firm is making more profit than the minimum required to keep the business operating in the long run.

This happens when price per unit (AR) exceeds average total cost.

AR > AC

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Supernormal profits

In the long run, the presence of supernormal profit can attract new firms to enter the market, which can eventually lead to increased competition (contestability) and reduced profits towards normal levels.

As new firms enter the market, th

The ease at which firms can enter and exit the market will depend on the barriers to entry within that industry/market.

AR > AC

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Economic losses

Economic losses are also known as subnormal profits.

In some cases, economic losses can be temporary – for example, because of a short-term increase in fixed or variable costs, or a drop in revenues caused by an inward shift in demand (AR and MR).

But economic losses sustained over time can threaten the commercial viability of a business. This might lead to a firm cutting back on output, employment and investment.

Eventually they may decide to shut-down parts of the business / leave the industry.

AR < AC

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INITIALLY, THIS FIRM MAKES A PROFIT AT PRICE P1

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

AR2

MR2

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

AR2

MR2

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

AR2

MR2

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

AR2

MR2

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LOSSES AFTER AN INWARD SHIFT OF DEMAND

ECONOMIC LOSSES

MC1

AC1

Cost & Revenue

Output

AR2

MR2

Loss = Q2(P2-C2)

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Economic losses - causes

Economic downturns - recessions and other economic downturns can significantly impact a business's profitability. This is especially true for firm’s whose demand is highly cyclical with a high coefficient of income elasticity of demand.
Rising costs - if a business is not able to control its variable costs or has high overhead (fixed) costs, it may not be able to generate enough revenue to cover its costs.
External shocks - many businesses have seen profits turn to losses during the pandemic and, afterwards, due to a surge in operating costs in 2022 and 2023.

AR < AC

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OPERATING LOSSES: CASE STUDY – THE PANDEMIC

The hospitality and tourism sectors suffered, with many businesses closing due to travel restrictions and reduced demand.
And, not surprisingly, the events and entertainment industries were hit hard, with concerts, festivals, and other live events being cancelled or postponed.
Aviation and other transport sectors were also hit hard by the pandemic.

ECONOMIC LOSSES

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PROFIT AND LOSS FOR EUROPEAN AIRLINES

ECONOMIC LOSSES

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OPERAING PROFIT AND LOSS FOR BRITISH AIRLINES

ECONOMIC LOSSES

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OPERATING PROFIT AND LOSS FOR WHITBREAD PLC

ECONOMIC LOSSES

Whitbread is a UK multinational leisure and hospitality company, best known as the owner of the Premier Inn hotel brand.

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REVENUE HIT FOR CINEMAS DURING THE PANDEMIC

Here are a few ways the UK and global cinema industry was hit hard:
Closed theatres: Many cinemas were forced to close for months or even longer due to lockdown restrictions.
Decreased attendance: Even when theaters reopened, many people were hesitant to go out in public, and attendance dropped significantly.
Delayed releases: Many major film releases were delayed or moved to streaming services, further hurting theaters.
Increased competition from streaming services: Netflix, Hulu, and others were already tough competition, but they became even more popular during the pandemic.

ECONOMIC LOSSES

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CINEMA INDUSTRY HIT HARD BY THE PANDEMIC

ECONOMIC LOSSES

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CINEMA INDUSTRY HIT HARD BY THE PANDEMIC

ECONOMIC LOSSES

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Economic losses - causes

Economic downturns - recessions and other economic downturns can significantly impact a business's profitability. This is especially true for firm’s whose demand is highly cyclical with a high coefficient of income elasticity of demand.
Rising costs - if a business is not able to control its variable costs or has high overhead (fixed) costs, it may not be able to generate enough revenue to cover its costs.
External shocks - many businesses have seen profits turn to losses during the pandemic and, afterwards, due to a surge in operating costs in 2022 and 2023.

AR < AC

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To show an economic loss

Draw your AC curve above the AR curve.

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GIVE ME TWO

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Microeconomic factors that might affect the profitability of businesses in an industry of your choice

BUSINESS PROFITS - FACTORS

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GIVE ME 2…

Microeconomic factors that might affect the profitability of businesses in an industry of your choice

Changes in variable and fixed costs: Variable costs might rise when prices for components, energy and raw materials increase. Depending on the coefficient of PED, the business might have to absorb rising costs in lower operating profit margins. An example is increasing costs in construction.

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BUSINESS PROFITS - FACTORS

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GIVE ME 2…

Microeconomic factors that might affect the profitability of businesses in an industry of your choice

Strength of competition / contestability in an industry: For example, the entry of new businesses into a market might lead to lower prices and cause a drop in supernormal profits. Applied examples might be the impact of the rapid growth of Lidl and Aldi on the profits of established UK food retailers.

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BUSINESS PROFITS - FACTORS

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Output

Profit maximising price (MC=MR)

Cost & Revenue

BUSINESS PROFITS - FACTORS

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Output

Cost & Revenue

BUSINESS PROFITS - FACTORS

AC2

MC2

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Output

Cost & Revenue

BUSINESS PROFITS - FACTORS

AC2

MC2

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Output

Cost & Revenue

BUSINESS PROFITS - FACTORS

AC2

MC2

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GIVE ME TWO

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Macroeconomic factors that might affect the profitability of businesses in an industry of your choice

BUSINESS PROFITS - FACTORS

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GIVE ME 2…

Macroeconomic factors that might affect the profitability of businesses in an industry of your choice

The exchange rate: A depreciation of the external value of a currency will – ceteris paribus – lead to an increase in the profitability of exporting products overseas. An increase in exports of cars causes an outward shift of demand (AR). But many exports require imports – which are more expensive

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BUSINESS PROFITS - FACTORS

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GIVE ME 2…

Macroeconomic factors that might affect the profitability of businesses in an industry of your choice

Rate of growth of aggregate demand: Consumption might fall if there is a rise in direct taxation which causes a fall in real disposable income. Businesses in industries such as luxury travel and tourism with a high-income YED will see a larger fall in demand than products with a lower YED.

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BUSINESS PROFITS - FACTORS

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Short-run shutdown price

The shutdown price is the price of a product at which a firm would rather shut down some of all their business than continue producing.

Basically, it's the point at which it's no longer profitable for a firm to keep producing and selling a product, so it decides to stop production altogether.

The shutdown price considers the fixed costs of production (like rent or equipment costs) and the variable costs (like labour or raw materials).

In the short run, a firm needs to cover its variable costs to keep producing.

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Cost & Revenue

Output

AVC

AC1

Here, the firm is more than covering AVC but not covering all fixed costs

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SHUT-DOWN PRICE

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Cost & Revenue

Output

AVC

AC1

P2 is the short-run shut-down price which just covers average variable cost

Shut Down Price

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SHUT-DOWN PRICE

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Long-run shutdown price

In the long run, the firm will shut down if the average revenue is less than the average total cost.

At this stage, the firm is unable to cover its variable costs and its fixed costs.