If you’re currently thinking about starting a business or are already handling one, one of the key concepts you should by heart is profit maximization. When we think of profit, there is always an assumption that if your sales are higher, you get higher profits. However, this is not necessarily applicable in all cases.
In our ultimate guide, we will be walking you through the theoretical aspect of profit maximization, the advantages and disadvantages of this concept, its limitations, and how it differs from other economic theories. Using this concept is not an automatic money generator(1). However, it will teach you to find the right balance between the quantity of your product and the price.
What is Profit Maximization?
In the jargon of economists, profit maximization occurs when marginal cost is equal to marginal revenue. You might have seen the profit maximization formula presented in economics textbooks as:
Marginal Cost = Marginal Revenue
In simpler terms, profit maximization occurs when the profits are highest at a certain number of sales. This all sounds complicated at first but don’t worry, we’ll be explaining all the concepts that were mentioned in the definition.
Profit Maximization Theory
Profit is defined as the money left over after subtracting all expenses from the funds coming from the sales of your product. For example, you sold lemonade for $1 per glass. It costs you $0.50 to produce per glass of lemonade. Let’s say that you were able to sell ten glasses of lemonade that day, so you have a revenue of $10 in total ($1 x 10). Take away the costs that were used to make those ten glasses ($0.50 x 10 = $5) from the total revenue ($10 – $5). This gives you a profit of $5.
Marginal revenue is defined as the revenue earned in producing one more unit of your item. In simpler terms, marginal revenue is the per-unit selling price of your item. In production, marginal revenue is an important concept because it helps firms make those efficient production decisions and maximize profits by looking at additional costs and revenue.
To determine marginal revenue, we can calculate it using the formula:
Marginal Revenue = Change in revenue / Change in quantity
To get the change in revenue, you must subtract the old revenue from the new revenue. Using the example from above, you were selling lemonade for $1 per cup. On your first day, you were able to sell ten glasses, giving you a revenue of $10 ($1 x 10). On your second day, you were able to sell 15 glasses, giving you a revenue of $15 ($1 x 15). Subtracting the old revenue from the new revenue ($15 – $10), your change in revenue is at $5.
To get the change in quantity, you must subtract the old quantity from the new quantity. In our example, we have ten glasses as our old quantity and 15 glasses as our new quantity. So, 15 glasses – 10 glasses will give you a change of quantity of 5 glasses.
Putting these two together, we can now calculate for our marginal revenue. Using the formula above, we take our change in revenue ($5) and divide it by the change in quantity (5 glasses). So, $5 / 5 glasses, this gives us an MR of 1. Thus, in the current level of production, the marginal revenue is at $1 per glass of lemonade.
In the market setting, it is usually the case that to sell more units, you have to reduce the price. Thus, in calculating and graphing the marginal revenue of different levels of sales and production, you might observe the general trend of a downward sloping line.
Marginal cost is defined as the cost that is incurred in producing one more unit of your item. In simpler terms, it is the per-unit cost of the item. The concept of marginal cost is important because it is needed in calculating profit maximization.
To calculate for the marginal cost, we use the following formula:
Marginal Cost = Change in cost / Change in quantity
To get the change in cost, you must subtract the old cost from the new cost. Let’s go back to our example with the lemonade so that you could visualize it better. On day one, you sold ten glasses of lemonade, which costs you $5 in total ($0.50 x 10). On day two, you sold 15 glasses of lemonade, now costing you $7.50 ($0.50 x 15). Taking these two numbers, we can now calculate the change in cost, which is $7.50 – $5 = $2.50.
To get the change in quantity, you must subtract the old quantity from the new quantity. In our existing example, you have ten glasses on day one, and 15 glasses on day two. The change in quantity is, therefore, five glasses (15 glasses – 10 glasses).
Now that we have the change in cost and change in quantity, we can now calculate for the marginal cost. Using the formula above, the change in cost will be divided by the change in quantity ($2.50 / 5 glasses), and we end up with $0.50. Therefore, we can conclude that the marginal cost of producing five additional glasses at this point is $0.50 per glass.
If you’re calculating the marginal cost for different levels of production, the graph will look like a line sloping down and comes back up. This is logical since per-unit costs will decrease while you increase the number of units produced. But once you reach capacity, your costs will increase because you will need to open a new facility or outsource the production to other firms.
Now that you’ve learned how to calculate both marginal revenue and marginal cost, you can now determine the point of profit maximization.
Monopoly Profit Maximization
But you might be wondering, “how about firms that are monopolizing a certain market?” One thing we should clarify here is that the same concept and formula for profit maximization we discussed above is applicable in any firm, regardless of the market structure that you’re operating in. However, because a monopoly firm won’t face any competition, its situation and decision-making process differs from a perfectly competitive firm.
In a perfectly competitive firm, the firm will act as a price taker and can choose to sell a relatively low quantity or relatively high quantity at the market price. Meanwhile, a monopoly can charge any price for its product or service but is still constrained by the demand.
Limitation of Profit Maximization in Financial Management
While it would seem that the goal of every business is to maximize profits, it is not always the best route to take if you want to address all the needs of your company. In an ideal and theoretical, you do not consider the other aspects in real-life situations such as customer retention, social, economic, and other goals you’ve set for your company. In this subsection, we are going to touch on the limitations of profit maximization in financial management.
Long-Term Sustainable Goals
While we all want our sales and profits to go up immediately, short-term increases in profit won’t help you reach your long-term sustainable goals. Using the theory of profit maximization might bring in extra money in the short-term; however, long-term earning might be drastically diminished.
For example, you might be thinking of lowering your production quality for the sake of driving up your profits. In effect, this upsets your customers, hurts your brand, and will be good news to your competitors. Another example would be selling all your items on inventory to a one-time client and driving away your loyal customers who could have given you more profits over time. These examples show you that you should always consider if your short-term profit maximization will be in support of your long-term sustainable goals.
Quality of the Product or Service
Another limitation of solely relying on the theory of profit maximization is the potential to decrease the quality of your product or service. If you are focused exclusively on profits, you are more likely to use lower quality raw materials, cut corners in production or delivery of services, or to sacrifice your company values. In effect, you lose your company’s good reputation and the trust of your customers.
Training of Employees
Another option to maximize profits is to cut employee training or the budget for research and development. While these reduce operating costs and maximizes your profits, it would not help you reach your long-term goals and even cause your employees harm. Employee training is essential for any company because it keeps them happy and satisfied. In turn, your employees will continue doing good work for your company.
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Advantages and Disadvantages of Profit Maximization
In applying any concept to a real-life situation, there will always be advantages and disadvantages. So, before you use the concept of profit maximization in your business, you must consider these:
- Prediction of real-world behavior. Using profit maximization allows you to predict the behavior of companies in a real-world situation. Firms behave without too much difficulty and with reasonable accuracy. This makes profit maximization useful for explaining and predicting business behavior.
- Knowledge of business firms. The profit motive is most influential in the behavior of business firms. For small firms with strong competition, they have to act as profit maximizes to increase their sales and reduce costs to survive the competition.
- Simple to use. The concept is simple, and there are a lot of mathematical tools available to help you with calculation.
- The ambiguity of profit. Some sources have pointed out that the concept of profit has never been unambiguously written down. Profit might refer to many things such as rate of profit, total, or net profits. These different definitions of profit have different implications for the price theory.
- No compulsion of competition for monopolist firms. For monopoly firms in the real world, they don’t need to maximize their profits since they earn above-normal returns. The monopoly market setting provides more alternatives than order conditions of perfect competition.
- Stress on other motives and interests. In a real-world situation, companies also focus on other motives because they are more important than profit maximization.
- Separation of ownership and control. In modern firms, there’s been a considerable separation between ownership and control. In turn, little attempt is made to maximize profits.
- One trade only. If you’re strictly following profit maximization, you might end up following one trade only. Nowadays, diversifying your business might be the better option to survive the competition.
- Legal restrictions. Some countries might implement laws to forbid firms from maximizing their profits.
Profit Maximization vs. Wealth Maximization
The main difference between the concept of profit maximization and wealth maximization is that the former is more focused on short-term earnings. Meanwhile, wealth maximization is focused on the overall value of the business in the long-term. We’ve listed the differences between the two in the table below:
|Pointers||Profit Maximization||Wealth Maximization|
|Planning duration||The short-term increase in profits is the most critical objective. Because of this, firms might decide not to pay for discretionary expenses.||Pays for discretionary expenditures such as advertising, research, and maintenance, which will help the business.|
|Risk management||Firms will opt to minimize expenditures. In turn, they are less likely to pay for hedges to reduce their risk profile.||Firms implement risk mitigation measures.|
|Pricing strategy||Firms will set prices as high as possible to increase their margins.||Firms do the reverse by reducing prices. In turn, they can build a market share in the long-term.|
|Capacity planning||Firms will only spend enough on their productive capacity to handle the current sales level and short-term sales forecast.||Firms will spend heavily on the capacity to meet long-term goals. While this entails larger investments, it will increase the value of the firm and payoff in the long run.|
Profit Maximization vs. Revenue Maximization
When you’re starting with a new business, it might seem like the top priority would be to make as much money as possible. But if you want to become successful in the long-term, you must also consider winning over customers to build a reputation in the market. The two motivations that we’ve mentioned are the essential difference between profit and revenue maximization, which is why it’s quite difficult for new businesses to choose the appropriate strategy.
As we have mentioned before, profit maximization occurs when the marginal cost is equal to marginal revenue. This takes into account the expenses you have incurred. Aside from the additional cash, profits may also be defined as a decrease in company liabilities, an increase in its assets, or an increase in the owner’s value in the company.
Meanwhile, revenue maximization dictates that the business should do whatever it takes to sell as much of the product at a high price as possible. However, revenue doesn’t take your expenses for production and marketing into consideration.
|Pointers||Profit Maximization||Revenue Maximization|
|Strategy||Uses cost control and wide profit margins to increase profits.||Open products and services to as many customers as possible. This is done by cutting costs, taking advantage of economies of scale, and trimming of profit margins.|
|Customers||Small but affluent customer base who are not sensitive to price.||New customers who are price sensitive.|
|Price setting||Artificially high prices which can be set for luxury items like designer clothes and bags .||Artificially low prices which can be set for items with low production costs and high sales volumes like staple food and electronic gadgets .|
Profit Maximization Problem and Example
To make things clearer, let’s take on another example. Let’s say a farmer produces bottles of chocolate milk and wants to determine the quantity where profits are at a maximum.
Consider the table below:
|Quantity||Price||Total Revenue</th?||Marginal Revenue||Total Cost||Average Total Cost||Marginal Cost||Profit|
In this example, the farmer will choose to produce three bottles of chocolate milk because this is where MC = MR. The farmer can earn $12 in profit in producing and selling three bottles of chocolate milk.
Frequently Asked Questions about Profit Maximization
Q. Why is profit maximization by itself an inappropriate goal?
A. While it would seem that the goal of every business is to maximize profits, it is not always the best route to take if you want to address all the needs of your company. If you are solely focused on profit maximization, you don’t consider real-life situations and aspects such as brand reputation, customer retention, employee satisfaction, environmental impact, and many more.
Q. What are the conditions of profit maximization?
A. Whether you’re determining profit maximization in a monopoly, oligopoly, or perfectly competitive setting, you will be using the same condition, which is MC = MR.
In this guide, we have discussed the theory of profit maximization, which states that if you want to maximize profits, the marginal cost should be equal to marginal revenue. While it is sometimes true that the higher your sales, the higher your profits. However, the profit maximization theory shows us that it is only true up until a certain number of units that you produce.
Profit maximization is an excellent tool to use in assessing the perfect approach in your new business. However, solely relying on profit maximization will not take into account the other aspects of a business, such as your customer base, brand reputation, and employee development and satisfaction. While profit maximization will seem like the priority in the short-term, focusing solely on this will not help your business thrive in the long-term.
Because of this, economists and business owners also look to wealth maximization and revenue maximization as tools to assess their business strategies. This is because both these concepts consider the long-term goals for a business to thrive. These include goals such as building a reputation for your brand and building your market share.
As different as these tools are, other experts suggest that you can use all or a mixture of these tools. Using the right tool will depend on which phase of the business you are in. One source suggests that you can focus on profit maximization during the initial stages of your business. Once your business has taken off and stabilized, you can focus on the long-term goals.