Profit maximisation of the individual firm

After you have worked through this section of the learning unit, you should be able to:

  • identify, describe and illustrate with the aid of diagrams the profit maximisation position of a firm

The goal of all firms is to maximise their profit. Under perfect competition, a firm cannot determine the price of the good or service it sells because it is a price taker. However, what it can decide on is the quantity of the good or service it will provide; and if it wishes to maximise its profits, it should set its quantity at such a level that it maximises its profit.

The profit maximisation position of the firm can be understood in terms of total revenue (TR) and total costs (TC), but can also be determined using marginal revenue (MR) and marginal cost (MC).

We will make use of the marginal revenue (MR) and marginal cost (MC) approach to determine the profit maximisation position of a firm under perfect competition.

You are given the following information:

The marginal cost of producing an additional fried chicken piece is R3,20. The marginal revenue of this additional fried chicken piece is R4. Should Funky Chicken produce this additional fried chicken piece?

Correct. The additional cost is only R3,20, while the additional revenue is R4. By producing this additional fried chicken piece, Funky Chicken adds 80 cents to its profits.

Incorrect. The additional cost is only R3,20, while the additional revenue is R4. By producing this additional fried chicken piece, Funky Chicken adds 80 cents to its profits.

According to the marginal revenue marginal cost approach, a firm under perfect competition should continue to increase its production as long as the marginal revenue exceeds the marginal cost. In other words, as long as the revenue of an additional unit is greater than the additional cost to produce that unit, profits are growing and it is worth producing the additional unit.

You are given the following information:

The marginal cost of producing an additional fried chicken piece is R6. The market price of a fried chicken piece is R4. Should Funky Chicken produce the additional unit?

Correct. The marginal cost is indeed greater than the marginal revenue since the marginal revenue is R4. Remember that P = MR. In this case, producing the additional unit will cost more than what it can be sold for and profits therefore decline. Funky Chicken should therefore not produce the additional unit.

Think again. The marginal cost is indeed greater than the marginal revenue since the marginal revenue is R4. Remember that P = MR. In this case, producing the additional unit will cost more than what it can be sold for and profits therefore decline. Funky Chicken should therefore not produce the additional unit.

Think again. Marginal revenue is equal to price is equal to R4.

As a general rule, we can now state the following:

  • If marginal revenue is greater than marginal cost (MR > MC), the firm should increase production.
  • If marginal revenue is equal to marginal cost (MR = MC), profit maximisation is reached.
  • If marginal revenue is less than marginal cost (MR < MC), the firm should decrease production.