In Microeconomics, 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.
Profit Maximization Rule
The formula for the profit maximization rule 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. It is also the slope of Total Revenue.
Profit = Total Revenue – Total Costs Therefore, profit maximization occurs at the biggest gap 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 greater than the cost, so you will produce more.
At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be greater than revenue, so you will produce less.
Thus, optimal quantity produced should be at MC = MR
Application of MC = MR
The MC = MR rule is quite versatile, firms can apply the rule to many other decisions. It can be applied to hours of operation: stay open as long as the added revenue from the additional hour exceeds the cost of staying open another hour. Or it can be applied to advertising: 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 made the decision to fly additional routes by asking whether the additional revenue from a flight (the MR) was greater than the per-flight cost of a flight. In other words, they used the rule MR = TC/q. 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 airlines 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. But 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 last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their good – which determines the MR.
2. It also depends on how other firms react. If they increase price, and other firms follow, demand may be inelastic. But, if they are the only firm to increase price, demand will be elastic.
3. It is difficult to isolate the effect of changing 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.