3.1.4. Output Optimization and Maximization of Profit

#cfa-level-1 #economics #reading-15-demand-and-supply-analysis-the-firm #section-3-analysis-of-revenue-costs-and-profit

Profit maximization occurs when

  • the difference between total revenue (TR) and total costs (TC) is the greatest;

  • marginal revenue (MR) equals marginal cost (MC); and

  • the revenue value of the output from the last unit of input employed equals the cost of employing that input unit (as later developed in Equation 12).

All three approaches derive the same profit-maximizing output level. In the first approach, a firm starts by forecasting unit sales, which becomes the basis for estimates of future revenue and production costs. By comparing predicted total revenue to predicted total costs for different output levels, the firm targets the quantity that yields the greatest profit. When using the marginal revenue–marginal cost approach, the firm compares the change in predicted total revenue (MR) with the change in predicted total costs (MC) by unit of output. If MR exceeds MC, total profit is increased by producing more units because each successive unit adds more to total revenue than it does to total costs. If MC is greater than MR, total profit is decreased when additional units are produced. The point of profit maximization occurs where MR equals MC. The third method compares the estimated cost of each unit of input to that input’s contribution with projected total revenue. If the increase in projected total revenue coming from the input unit exceeds its cost, a contribution to total profit is evident. In turn, this justifies further employment of that input. On the other hand, if the increase in projected total revenue does not cover the input unit’s cost, total profit is diminished. Profit maximization based on the employment of inputs occurs where the next input unit for each type of resource used no longer makes any contribution to total profit.


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