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Profit Maximization Model of a Firm

The efficient management of a business firm requires an optimal or
best solution out of the available courses of action for a firm.

This efficient or optimal decision making requires establishing the

goal or objective to be achieved.

Whether a management decision is optimal or not can be evaluated

against the goal or objective that the firm seeks to achieve.

1. Profit Maximisation Model:

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In traditional economic model of the firm it is assumed that a firm’s

objective is to maximise short-run profits, that is, profits in the
current period which is generally taken to be a year. In various
forms of market structure such as perfect competition, monopoly,
monopolistic competition the traditional microeconomic theory
explains the determination of price and output by assuming that
firm’s aim is to maximise current or short-run profits. This current
short-run profit maximisation model of the firm has provided
decision makers with useful framework with regard to efficient
management and allocation of resources.

Profit is a difference between total revenue and total cost. It may be

noted that the concept of cost used in economic theory and
managerial economics is different from the concept of accounting
cost used by accountants. This difference in the concepts of costs
makes the concept of profits used in economic theory different from
that used in its calculation by the accountant.

It is to state here that economic profits is the difference between

total revenue and economic costs. Thus,

=TR-TC
Where stands for total economic profits, TR for total revenue and
TC for total economic costs. It is economic profits which firms try to
maximise in their decision making about level of output to be
produced and price to be charged for its product. This is illustrated
in Fig.2.1. where TR curve represents total revenue earned from
selling varying amounts of output of a product. TC curve depicts
total economic costs at different levels of output. It will be seen from
the upper part of Fig.2.1 at OM level of output, total revenue equals
total economic costs and therefore at this level of output the firm is
just breaking even.
Therefore, point B at which TR curve cuts TC curve is called break-
even point. Beyond this break-even level of output positive profits
start accruing to the firm as it expands its level of output. Profits go
on increasing till output level OQ is reached. It will be seen from the
upper part of Figure 2.1 that at output OQ, the difference between
total revenue and total cost is maximum, that is, JH is the largest
distance between the TR and TC curves.

Therefore, JH is the maximum profits that can be earned by the

firm, given the total revenue and total cost conditions.

That the profits are maximum at output level OQ can be

shown mathematically as under:
= TR – TC
For the total profits to be maximum, the first derivative of the total
profit function should be zero. Thus, taking the first derivative of (1)
above we have

d =d (TR) /dQ-d (TC) dQ =0

or , d (TR)/ dQ= d(TC) dQ

d (TR) /dQ and d(TC) dQ and are the slopes of TR and TC curves
respectively.

It will be seen from Fig.2.1 that the slope of the TR and TC curves
corresponding to output level OQ are the same as the slope of the
tangents drawn to these curves are the same at this output level.

In the lower part of Figure 2.1 we have drawn a total profit curve TP
which first rises and then beyond point N (corresponding to output
level OQ) it starts falling indicating that profits are maximum at
output level OQ.
It can be seen from the upper part of Figure 2.1 that profits start
declining as output is expanded beyond OQ. Therefore, a firm which
aims to maximise profits will produce output level of OQ, and will
charge a price of its product which buyers are prepared to pay
depending on the demand conditions.

Since price or average revenue equals total revenue divided by a

level of output, price charged by the firm at output level OQ is given
TR/OQ or QJ/OQ

The simple profit-maximizing model of the firm provides very useful

guidelines for the decision making by the firm with regard to
efficient resource management.

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Thus, any business decision by a firm will increase its

profits if the following conditions prevail:
1. It brings about increase in total revenue more than increase in
costs.

2. It causes increase in revenue, costs remaining unchanged.

3. It reduces cost more than it reduces revenue.

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4. It reduces costs, revenue remaining the same.

2. Limitations:
Despite the merits of the profit maximising model of the firm, it has
two important limitations. First, it does not incorporate time
dimension in the decision-making process by the firm. Secondly, it
does not analyse the firm’s behaviour under conditions of risk and
uncertainty. The modern model of the firm known as ‘Firm’s value
Maximization Model ‘or Shareholder’s wealth Maximising Model’
overcomes these limitations by incorporating time dimension into
the managerial decision-making process. This model also considers
risk involved in business decision-making.
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Bain’s Models for Limit-Pricing Theory of Markets
Bain formulated his ‘limit-price’ theory in an article published in
1949, several years before his major work Barriers to New
Competition which was published in 1956.

His aim in his early article was to explain why firms over a long
period of time were keeping their price at a level of demand where
the elasticity was below unity, that is, they did not charge the price
which would maximize their revenue.

His conclusion was that the traditional theory was unable to explain
this empirical fact due to the omission from the pricing decision of
an important factor, namely the threat of potential entry.
Traditional theory was concerned only with actual entry, which
resulted in the long-run equilibrium of the firm and the industry
(where P = LAC).
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However, the price, Bain argued, did not fall to the level of LAC in
the long run because of the existence of barriers to entry, while at
the same time price was not set at the level compatible with profit
maximization because of the threat of potential entry. Actually he
maintained that price was set at a level above the LAC (= pure
competition price) and below the monopoly price (the price where
MC = MR and short-run profits are maximized).

This behaviour can be explained by assuming that there are barriers

to entry, and that the existing firms do not set the monopoly price
but the ‘limit price’, that is, the highest price which the established
firms believe they can charge without inducing entry. Bain, in his
1949 article, develops two models of price setting in oligopolistic
markets.

Assumptions:
1. There is a determinate long-run demand curve for industry
output, which is unaffected by price adjustments of sellers or by
entry. Hence the market marginal revenue curve is determinate. The
long-run industry-demand curve shows the expected sales at
different prices maintained over long periods.

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2. There is effective collusion among the established oligopolists.

3. The established firms can compute a limit price, below which

entry will not occur.

The level at which the limit price will be set depends:

(a) On the estimation of costs of the potential entrant,

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(b) On the market elasticity of demand

(c) On the shape and level of the LAC,

(d) On the size of the market,

(e) On the number of firms in the industry.

4. Above the limit price, entry is attracted and there is considerable

uncertainty concerning the sales of the established firms (post
entry).

5. The established firms seek the maximization of their own long-

run profit.

Model A: there is no collusion with the new entrant:

Assume that the market demand is DABD’ and the corresponding
marginal revenue is Dabm (figure 13.1).

Assume further that the limit price (PL) is correctly calculated (and
known both to the existing firms and to the potential entrants).
Given PL, only the part AD’ of the demand curve and the section am
of the MR are certain for the firms. The part to the left of A, that is,
DA is uncertain, because the behaviour of the entrant is not known.
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Whether the firms will charge the PL or not depends on the

profitability of alternatives open to them, given their costs.
Assume the LAC (which is uniquely determined by the addition of
the LMC = LAC of the collusive oligopolists) is LAC1. In this case two
alternatives are possible.
Either to charge the PL (and realise the profit PLAdPc1 with certainty).
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Or to charge the monopoly price, that is, the price that corresponds
to the intersection of LAC1 = MC1 with the MR. This price will be
higher than PL (given LAC1), but its precise level is uncertain post-
entry. Thus the profits in the second alternative are uncertain and
must be risk-discounted. The firm will compare the certain profits
from charging PLwith the heavily risk-discounted profits from the
second ‘gamble’ alternative, and will choose the price (PL or PM) that
yields the greatest total profits.
Assume that the LAC is LAC2 = MC2. In this case the price that
maximises profit is PM2 (corresponding to the intersection MC2 and
MR over the certain range of the latter). The PM2 is lower than PL.
The firm will clearly charge PM2 which maximises the profits. In this
case the ceiling set by the price PL is not operative.
The observed fact of setting the price at a level where e < 1 is
justified by a situation where the limit price is low, cutting the
demand curve at a point at which the MR is negative (figure 13.2).
Clearly if the limit price is PL* the MR is b* which is negative and
hence the elasticity of demand at price PL is less than unity.

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In summary: given that an entry-preventing price PL is

defined, the alternatives open to the established firms are
three:
1. To charge a price equal to PL and prevent entry.
2. To charge a price below PL and prevent entry (this will be adopted
if PM < PL).
3. To charge a price above PL and take the risks associated with the
ensuing entry and the indeterminate situation that arises in the
post-entry period. (This course of action will be in any case adopted
if PL < LAC).
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The firm will choose the alternative which maximises profit.

Model B: collusion takes place with the new entrant:

With collusion assumed to take place between the established firms
and the entrant the conclusions are as before. The model is easier,
however. With collusion the whole D curve shifts to the left by the
share which is allocated to the new entrant at each price. The new
DD” curve is known with certainty at all its points, as a consequence
of the collusion, and so is the corresponding m” (figure 13.3).

Again the alternatives open to the firm are three:

1. Either charge PL and exploit AD’ without entry.
2. Or charge a price above PL and attract entry. The firm will
eventually move to a point on the share-of-the-market curve DD”,
via collusive agreement with the new entrant.
3. Or charge the profit-maximizing price PM, if PM < PL.
Among these alternatives the firm will choose the one that yields
maximum profits.

The basic and crucial assumptions of the above analysis are firstly,
that the entrants react on the basis of the current price they expect
the price charged by the established firms to continue in the post-
entry period; secondly, that the established firms are aware of the
threat of potential entry; thirdly, that the established firms can
estimate correctly the limit price.

Then three major possibilities exist:

The policy of pricing to maximize industry profit with no entry
resulting is adopted when PL > PM, i.e. the limit price is not operative
because by charging the lower PM price (monopoly price
corresponding to MC = MR) profits (certain in this case) are
maximized.
Pricing to forestall entry with industry profits not maximized, but
the profit of established sellers maximized, is adopted when PL <
PM and the certain profit accruing by charging PL is greater than the
heavily risk-discounted profit which would accrue if the higher
PM were charged and an uncertain quantity sold.
Pricing to maximize industry profit but with resulting entry. This
implies PM > PL. This action would be chosen if it is more profitable
as compared with charging PL and necessarily, if PL < LAC.
The first two situations lead to long-run equilibrium of the industry
without entry or exit. The third case implies an unstable equilibrium
since entry would be taking place.

In all the above cases one should add to the profits of established
sellers any transitional profit which the established sellers might
gain while raising the price above PL and before entry became
effective.
The new element of Bain’s model is the redrawing of the market
demand so as to account for the threat of entry. Once the demand is
redefined, the model accepts collusion and profit maximisation as
valid hypotheses, capable of explaining the policy of setting a price
below the monopoly level, that is, below the level that maximises
profit. Bain’s model is not incompatible with profit maximisation.

The limit price will be chosen in favour of monopoly price if the

former yields maximum long-run profits. The rationale of adopting
an entry-prevention policy is profit maximisation. Whenever such a
limit price is adopted it is implied that the firm has done all the
relevant calculations of profits of alternative policies and has
adopted the limit price because this yields maximum profits.
Differences Between Full Cost & Marginal Cost Pricing Strategies
Pricing products is a difficult but essential part of running a business. One possible
starting point is the cost of each item for sale. The price can be adjusted based on
the cost -- the higher the price, the higher the profit margin on that item. However,
cost can be measured as the full cost of the item or the marginal cost. Each cost
strategy produces different results and has different benefits and drawbacks.

Marginal Cost Pricing

In marginal cost pricing, the benchmark cost for each outcome is the cost required to
produce it. This cost does not include fixed costs of the business, such as rent
payments, which do not vary with the level of production. Marginal cost is only the
cost of the labor, material and other direct inputs for producing each item. Under
marginal cost pricing, the business would first decide how much to produce and then
set its price based on the marginal cost of the last unit it produces.
Advantages and Disadvantages
From the perspective of economics theory, marginal-cost pricing leads to the most
profitable prices in any type of market. However, it can be difficult for a business
owner in the real world to calculate marginal costs, because owners and managers
tend to conflate marginal costs with other types of costs, such as fixed costs and
sunk costs. Research from the Kellogg School at Northwestern University even
indicates that some market structures discourage marginal-cost pricing by rewarding
price increases that arise when managers take fixed and sunk costs into account.
Full-Cost Pricing
Full-cost pricing seeks to include every cost of running a business in the cost of
producing goods. These costs include rent, a fixed cost or initial outlays of money for
purchasing and renovating a location, which is a sunk cost. The pricing manager
attributes total costs of the business equally to each item produced for sale. Full
costs are higher than marginal costs, because they include more than just the
variable costs associated with production.
Full-Cost Issues
Full-cost pricing generally fails to achieve the theoretically optimal profit-maximizing
price. This is because the manager will include sunk and fixed costs in the decisions
about how much of each item to produce and what their prices should be. However,
those costs, by definition, do not vary with the level of production, so they should not
affect production-level decisions. On the other hand, full cost is relatively easy to
measure -- simply add up all the costs of the business and divide by the amount of
items the owner or manager wants to sell.
Joint Costs Definition
In accounting, a joint cost is a cost incurred in a joint process.
Joint costs may include direct material, direct labor, and overhead costs
incurred during a joint production process. A joint process is
a production process in which one input yields multiple outputs. It is a
process in which seeking to create one type of
output product automatically also creates other types of output product.
Joint Process Examples
Joint processes are production processes in which the creation of
one product also creates other products. It is a process in which one input
yields multiple outputs. Joint production processes are common in the
agriculture industry, the food manufacturing industry, and the chemical
industry.
For instance, let’s consider a poultry plant. The plant takes live chickens
and turns them into chicken parts used for food. The chickens yield
chicken breasts, drumsticks, livers, gizzards, and other parts of the chicken
that are used for human consumption. They also yield miscellaneous
chicken byproducts that are used for hotdogs, jerky sticks, or animal
provender.

Similarly, let’s consider an oil refinery. The refinery takes crude oil and
refines it into a substance that may be used for auto gasoline, motor oil,
heating oil, or kerosene. All of these various outputs come from a single
input – crude oil. In both of these examples, a single input yields multiple
outputs. These are both examples of joint production processes.
Joint Cost Allocation
Allocate joint costs to the primary output products of the joint process,
not the incidental byproducts or scrap. Allocate them using a physical
measure or a monetary measure.
The physical measure allocates joint costs to primary products based on a
physical characteristic, such as units produced, or pounds or tons
produced, barrels produced, or some other physical measure that is
appropriate for the volume of output of the primary products. To use this
method, simply divide the total production cost by the appropriate
measure of output volume to yield the cost per unit of output.
One type of monetary measure of joint cost allocation is the sales value
method. Using the sales value method, separate and differentiate the
primary products according to sales value. Then divide them into
proportions of sales value that add up to 100%. Then multiply the
percentage proportions by the total production cost to yield the allocated
cost per primary product type.

Methods to allocate joint production cost

A true joint cost has a characteristic of indivisibility. The methods used to apportion or
allocate a joint cost are therefore arbitrary and not perfect. The four acceptable joint cost
allocation methods are given below:

1. Market or sales value method

The market or sales value method allocates a joint production cost on the basis of
relative market or sales values of individual joint products.

Under market or sales value method, the joint cost incurred in a joint production
process is allocated to different joint products on the basis of their market or sales value.

The method refers to a systematic allocation of joint cost attached to a specific joint
production process based upon the real market or sales value of the products that come
into existence as a result of running that joint production process. The method makes
use of a weighted average of market values of all the joint products and the cost is
apportioned amongst the products based on their respective shares of sales values.

The market value method is an industry preferred method for allocating joint cost among
joint products because the market or sales value of any product is considered one of the
most reliable indicator of its economic value and the costs attached to it.

2. Quantitative or physical unit method

This method uses some physical measurement units (such as volume, weight etc.) to
allocate joint production cost.

Under quantitative unit method (also known as physical unit method), the joint cost is
allocated among joint products on the basis of measurement units like tons, gallons,
pounds or feet etc.

To use this method, all the joint products must be measurable by some basic unit of
measurement. In situations where such measurement is not possible, the joint products
must be converted to some common denominator. For example, while manufacturing
coke, the joint products like coke, benzol, coal tar, gas and sulfate of ammonia are
measured in different units and the yield of recovered units of these products is
measured on the basis of product quantity extracted per ton of coal used

3. Average unit cost method

The average unit cost method, as the name implies, uses average unit cost to allocate
the cost before split-off point.

Under average unit cost method, as the name implies, an average unit cost is
calculated and used to apportion a joint production cost among all the joint products. The
average unit cost is calculated by dividing the total joint production cost incurred by the
total number of units of joint products produced.

The average unit cost method is very simple to employ for allocating a joint production
cost to joint products because it considers all the joint products as the same units.
However, the method is viable only for those production processes in which the
difference between the joint products is very small. If a process produces joint products
that substantially differ from each other, the average unit cost method would not be a
suitable option for the allocation of joint costs

4. Weighted average method

This method assigns predetermined weight factors to joint products based on various
factors such as price, production complexity and unit size of the product.

Under weighted average method of joint cost allocation, certain predetermined weight
factors are assigned to each unit of joint products. The finished units are multiplied by the
weight factors to obtain the number of weighted units which are then used to prorate the
total joint production cost among individual units of joint products. For example 10,000
units of product X and 20,000 units of product Y are produced in a joint production
process. If a weight factor of 5 is assigned to product X and a weight factor of 3 is
assigned to product Y, the weighted number of units of product would be computed using
the following formula:

Weighted units = Units produced × weight factor

The number of weighted units of product X and product Y would be computed as follows:

 Weighted units of product X: 10,000 units × 5 points = 50,000 units

 Weighted units of product Y: 20,000 units × 3 points = 60,000 units

The weight factors are determined for each joint product on the basis of core product
characteristics and manufacturing requirements such as amount of direct materials used,
size of the unit of product, difficulty or complexity involved in manufacturing a unit of
product, amount of time required to manufacture a unit of product and the type of labor
engaged to complete the production etc.

Like traditional average unit cost method, the application of weighted average method is
simple and straight forward. However, it is used in industries where other available
methods such as market value method, quantitative unit method and average unit cost
method cannot be satisfactorily used for the allocation of joint production costs.
Welfare implications of monopoly pricing:

Monopoly Power and Economic

Efficiency and Welfare
The conventional argument against market power is that monopolists can
earn abnormal (supernormal) profits at the expense of efficiency and the welfare
of consumers and society.

The case against monopoly

The monopoly price is assumed to be higher than both marginal and average costs leading to a
loss of allocative efficiency and a failure of the market. The monopolist is extracting a price
from consumers that is above the cost of resources used in making the product and,
consumers' needs and wants are not being satisfied, as the product is being under-consumed.

The higher average cost if there are inefficiencies in production means that the firm is not
making optimum use of scarce resources. Under these conditions, there may be a case for
government intervention for example through competition policy or market deregulation.

Possible X Inefficiencies under Monopoly

The lack of competition may give a monopolist less incentive to invest in new ideas. Even if
the monopolist benefits from economies of scale, they have little incentive to control their
costs and 'X' inefficiencies will mean that there will be no real cost savings compared to a
competitive market.

A competitive industry will produce in the long run where market demand = market supply.
Price = MC and the industry meets the conditions for allocative efficiency.

If the industry is taken over by a monopolist then the monopolist is able to charge a higher
price restrict total output and thereby reduce welfare because the rise in price reduces
consumer surplus.

Some of this reduction in welfare is a pure transfer to the producer through higher profits, but
some of the loss is not reassigned to any other agent. This is known as the deadweight
welfare loss or the social cost of monopoly

Potential Welfare Benefits from Monopoly

 A high market concentration does not always signal the absence of competition;
sometimes it can reflect the success of firms in providing better-quality products, more
efficiently, than their rivals
 One difficulty in assessing the welfare consequences of monopoly, duopoly or
oligopoly lies in defining precisely what a market constitutes! In nearly every industry
 a market is segmented into different products, and globalization makes it difficult to
gauge the degree of monopoly power.

What are the main advantages of a market dominated by a few sellers?

Economies of Scale

A monopolist might be better placed to exploit increasing returns to scale leasing to an

equilibrium that gives a higher output and a lower price than under competitive conditions.
This is illustrated in the next diagram, where we assume that the monopolist is able to drive
marginal costs lower in the long run, finding an equilibrium output of Q2 and pricing below
the competitive price.

Possible welfare gains from monopoly

Monopoly Profits, Research and Development and Dynamic Efficiency

 Patents provide legal protection of an idea or process. Generic patents allow legal
copying of a product.
 As firms are able to earn abnormal profits in the long run there may be a faster rate of
technological development that will reduce costs and produce better quality items for
consumers.
 Monopoly power can be good for innovation
 Despite the fact that the market leadership of firms like Microsoft, Toyota,
GlaxoSmithKline and Sony is often criticised, investment in research and
development can be beneficial to society because they expand the technological
frontier and open new ways to prosperity.
 Many innovations are developed by firms who then look to apply for patents on
'leading-edge' technologies.