Profit Maximisation Objective

• In economics, it is usually assumed that a firm’s main objective is to maximise profit (or minimise loss).
• Firms may also want higher sales, growth, survival, a good image, or better salaries for staff, but for analysis we treat profit maximisation as the primary objective because it helps us predict output and price decisions.

Key idea: A firm chooses that level of output where its profit is highest. At this level, the firm is in equilibrium because it has no reason to increase or decrease output.

• Total Revenue (TR): Money received from selling output.
  $TR=Price\; per\; unit\times Quantity\; sold$
• Total Cost (TC): Total economic cost of production (includes explicit and implicit costs and normal profit).

Economic profit (π):

π = TR − TC

• Profit is maximised at the output where the difference between TR and TC is the greatest.

Per-unit profit:

Per unit profit = AR − AC 

• AR (Average Revenue) = TR ÷ Q = price per unit.
• AC (Average Cost) = TC ÷ Q.

A profit-maximising firm chooses that output where the gap between AR and AC (per-unit profit) is maximum.

Normal profit

• Normal profit is the minimum earning needed to keep a firm in the industry.
• It is the opportunity cost of the entrepreneur’s own capital and effort.
• In economics, normal profit is treated as part of the cost of production and included in TC.

Pure / economic / super-normal profit

• Pure (economic or supernormal) profit is the extra profit over and above all costs, including normal profit.
• It is the excess of revenue over total cost (including normal profit).

Simple outcomes

• If TR = TC, then the firm earns only normal profit (no pure profit).
• If TR > TC, firm earns pure/supernormal profit.
• If TR < TC, then the firm makes a loss.

• Positive pure profits act as a signal that an industry is doing well, so more resources (capital, labour, etc.) move into that industry.
• Losses (negative profits) signal that resources can be used better elsewhere, so resources move out of that industry.
• Thus, profit and loss guide allocation of resources among different industries.

A firm is in equilibrium when it produces the profit-maximising output.
There are two equivalent approaches used to explain this:

1. Total Revenue – Total Cost (TR–TC) approach
2. Marginal Revenue – Marginal Cost (MR–MC) approach

These rules apply under all market structures (perfect competition, monopoly, etc.).

• Maurice Allais (1911–2010) was a French economist and the first French citizen to receive the Nobel Prize in Economics (1988).
• He made important contributions to the theory of market behaviour and efficient allocation of resources, similar to the work of economists like J. R. Hicks and Paul Samuelson.
• His work covered utility theory, decision theory, economic power, and monetary policy.

Imagine a pizza shop:

• If it makes very few pizzas, it does not fully use its kitchen and staff → profit is low.
• As it increases output, its revenue rises faster than cost, so profit increases.
• Beyond a certain level, it needs overtime and extra ingredients, and may have to give discounts → cost per extra pizza rises and may be more than the extra revenue.

The shop maximises profit at the output where:

• Extra revenue from one more pizza = extra cost of making that pizza
  → MR = MC.

At this point, any change in output (more or less) reduces profit.

• Firms are assumed to mainly aim at profit maximisation.
• Economic profit = TR − TC.
• Normal profit is the minimum reward needed to keep a firm in the industry and is part of the cost.
• Pure (economic/supernormal) profit is the extra over and above all costs, including normal profit.
• Under the TR–TC approach, profit is maximum where the TR–TC gap is the largest.