The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR.
Profit Maximization Rule Formula
The profit maximization formula is
MC = MR
Marginal Cost is the increase in cost by producing one more unit of the good.
Marginal Revenue is the change in total revenue as a result of changing the rate of sales by one unit. Marginal Revenue is also the slope of Total Revenue.
Profit = Total Revenue – Total Costs
Therefore, profit maximization occurs at the most significant gap or the biggest difference between the total revenue and the total cost.
Why is the output chosen at MC = MR?
At A, Marginal Cost < Marginal Revenue, then for each extra unit produced, revenue will be higher than the cost so that you will generate more.
At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be higher than revenue so that you will create less.
Thus, optimal quantity produced should be at MC = MR
Application of Marginal Cost = Marginal Revenue
The MC = MR rule is quite versatile so that firms can apply the rule to many other decisions.
For example, you can apply it to hours of operation. You decide to stay open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.
Or it can be applied to advertising. You should increase the number of times you run your TV commercial as long as the added revenue from running it one more time outweighs the added cost of running it one more time.
Example of Profit Maximization
In the early 1960s and before, airlines typically decided to fly additional routes by asking whether the extra revenue from a flight (the Marginal Revenue) was higher than the per-flight cost of the flight.
In other words, they used the rule Marginal Revenue = Total Cost/quantity
Continental Airlines broke from the norm and started running flights even when the added revenues were below average cost.
The other airlines though Continental was crazy – but Continental made huge profits. Eventually, the other carriers followed suit. The per-flight cost consists of variable costs, including jet fuel and pilot salaries, and those are very relevant to the decision about whether to run another flight.
However, the per-flight cost also includes expenditures like rental of terminal space, general and administrative costs, and so on. These costs do not change with the number of flights, and therefore are irrelevant to that decision.
Limitations of the Profit Maximization Rule (MC = MR)
1. In the real world, it is not so easy to know exactly your Marginal Revenue and Marginal Cost of the last products sold. For example, it is difficult for firms to know the price elasticity of demand for their good – which determines the MR.
2. The use of the profit maximization rule also depends on how other firms react. If you increase your price, and other firms may follow, demand may be inelastic. But, if you are the only firm to increase the price, demand will be elastic.
3. It is difficult to isolate the effect of changing the price on demand. Demand may change due to many other factors apart from price.
4. Increasing price to maximize profits in the short run could encourage more firms to enter the market. Therefore firms may decide to make less than maximum profits and pursue a higher market share.