Marginal revenue means the addition made to the total revenue by producing and selling an extra unit of output. According to this approach a firm will go on expanding the level of output so long as an extra unit of output adds more to revenue than to cost, since it will be profitable to do so. No firm will produce such output which adds more to cost than to revenue because to provide that unit will mean negative profits. Alternatively, it will pay the firm to expand extra unit of output so long as the marginal reve4nue (MR) exceeds marginal cost (MC). The firm will be increasing its total profits by increasing its output to the level at which MR =MC. It will not be profitable for the firm to produce a unit of output where MC >MR.
There are two conditions that must be fulfilled for the profit to be maximized:
Marginal Revenue must be equal to marginal cost (MR –MC)
MR =MC, must be satisfied under the condition of MC cuts MR from below.
The whole argument explained above can be better understood by the help of figure (1.2) which portrays hypothetical MR and MC curves of a firm. In figure, MR curve is sloping downward and MC curve in the beginning is falling but after a point it is sloping upward. Two curves MR and MC intersect each other at point E where firm will be maximizing its profits by producing OX2 level of output. Up to OX2 level of output MR is greater than MC. Thus, the firm will be making maximum profits and will therefore be in equilibrium by this approach at the level of output at which MR =MC or where the MR and MC curves intersect each other.
The second condition that must be fulfilled for the profit to be minimized requires that for a firm to be in equilibrium MC must cut MR from below at the point of equilibrium. If MC curve cuts MR from above at the MR MC, then beyond this equality, MC would be lower than MR and it will be profitable tor the firm to expand its output beyond this equality point. In figure (1.2) MC curve is U-shaped and is cutting MR curve at two points E and E1. The firm can not be in equilibrium at point E (or output OX1) at which MC = MR because at this point MC curve is cutting MR curve from above and it will be profitable for the firm to expand output beyond OX1. At output OX2 where MR = MC and also MC is cutting MR from below, the firm will be in equilibrium position. This is so because beyond OX2 level of output slope of MC is greater than slope of MR and therefore it will not be worth while to produce more than OX2 output.
Mathematical Version
We know that a profit maximizing firm seeks to maximize
p= TR- TC
Where,
p = Total profit
TR = Total revenue
TC = Total cost
First Order/ Necessary Condition
First order condition of profit maximization is that the first order derivative of the profit function must be equal to zero.
Second Order Condition/ Sufficient Condition
The second order condition for maximizing a profit function requires that its second derivative be negative. When second derivative of profit function be negative, it implies that at profit maximizing level the slope of MR curve must be less than the slope of MC curve, MC curve must cut MR curve.
Controversy over Profit maximization Objective
Theory vs. Practice: Traditional theory assumes profit maximization as the only objective of a business firm. In practice, however, firms have been found to be pursuing objectives other than profit maximization such as sales maximization, revenue maximization, a target profit, retaining market share, value maximization, welfare maximization, etc.
The profit maximization objective, as operationally defined, suffers from a number of technical flaws.
?There is lack of precision. The profit maximization objective fails to define which profits are to be maximized short run or long run profits. If short run profits are to be maximized, whether then expenditure on research and development has to be sacrificed so that total cost and therefore per unit cost can be reduced. But this decision’ will have an adverse impact on both long run profitability and long- run survival of the firm.
? Generally there is no uniform definition of profits, that whether the firm should maximize the total amount of profits or the rate of profit. What should be the correct measure of the rate of profit? Should the rate of profit be related to total capital or to shareholder’s equity? Should the accounting profits be maximized or should it be the cash flow?
? The profit maximization model suffers from grate defect, viz., it is a static model and fails to incorporate time dimension in the decision process. Since the firm collects its revenue and incurs cost over a long period of time, (i.e. during the life of the plant) and it is difficult to estimate revenues generated and different costs incurred in each future period. In this way static profit maximization model does not offer any basis for comparing alternatives that are expected to generate varying flows of revenues and expenditures overtime.
? Another serious defect of this objective is its failure to0 deal explicitly with risk and uncertainty involved in decision-making. Tow alternative projects involving generation of identical expected revenue in future periods and incurring of identical outlays may be subject to varying degrees of uncertainty as regards benefits and costs. The greater the degree of uncertainty, greater is the risk accompanying the project.
? The Marginality Principle of equalizing MC and MR has been ignored to be in the decision-making process of the firms. Empirical studies of the pricing behavior of the firms have shown that the marginal rule of ‘pricing does not stand the test of empirical verification. Hall and Hitch have found, in their study of pricing practices of 38 firms, that the firms do not pursue the objective of profit maximization and that they do not use MC = MR principle in their price and output decision. But in the short-run, they set the price of their product on the basis of average cost principle, so as to cover AC = AVC + AFC and a normal margin of profit (usually 10 percent).
While the controversy on profit maximization objective remains unresolved, the conventional theorists, the marginality, continue to defend the profit maximization objective and its marginality rules. The conventional economic theorists defend the profit maximization assumption also on the following grounds.
? Only those firms survive in the long run specially in a competitive market which is able to make a reasonable profit. Once they are able to make profit, they would always try to make it as large as possible. All other objective are subject to this primary objective.
? This assumption has been found to be accurate in predicting certain aspects of firms’ behavior. Friedman argues that the validity of profit maximization objective cannot be judged by a priori logic or by asking the business executive. The ultimate test is this ability to predict the business behavior and trends.
? Profit maximization is a time-honored objective of a business firm and evidence against this objective is mot unambiguous.
? Though not perfect, profit is the most efficient and reliable measure of efficiency of a firm. It is also the source of internal finance. In developed economics, internal source contributes more than three fourths of the total finance.
There is no doubt that the profit strategies of certain business have raised ethical questions. For example, the late 1990s saw a rash of charges leveled at U.S firms that subcontracted to domestic producers who ran sweatshops or to foreign sweatshop operators who employed child labor. Such well-known names Liz Claiborne, the Gap, Nike, WalMart, and Kathie Lee Gifford were involved in the controversies that flared when the situation was publicized. The sweatshop incidents were followed in the early 2000s by several cases of alleged fraudulent accounting and scandalous insider trading related to some of the biggest corporate bankruptcies in U.S. history (Enron, Worldcom). Naturally, these discoveries raised questions regarding ethics and profit-maximizing behavior.
Tow business ethics scholars, Patrick Primeaux and John Stieber, produced an interesting article that addressed the connection between profit maximization and the laws, ethics, and mores of society. Primeaux, a Marist Father and theology professor at St. John’s University (in New York), and Stieber, a professor in finance and economics at Southern Methodist University (Dallas), argued that profit-maximizing managerial decisions are inherently quite consistent with ethical behavior. Primeaux and Stieber began their analysis with the proposition that in business, as in football or baseball, there are rules of the game. Those rules are related to the role of the manager in the social system as a whole, where business managers serve the function of allocating scarce resources.
Primeaux and Stieber explained that managers are driven to be efficient in the use of resources because, if they are not, their business will not be profitable, or, at least, be as profitable as they could be. Thus, there is an ethical dimension to profit maximization, since faikure to produce the “right” amount output (failure to operate where MR=MC) misallocates resource, resulting in the supply of either too little or too much of the firms product. When resources are misallocated, society as a whole pays the bill, so that consumers, shareholders, managers, and employees will eventually be worse off. The authors stated:
From a behavioral perspective profit maximization is defined as the act of producing the right kind and the right amount of goods and services the consumer wants at the lowest possible cost (within the legal and ethical mores of the community).
They added that the phrase, “within the legal and ethical mores of the community,” was placed in parentheses because community standards are already contained within the costs of the firm.
The idea that the legal and ethical mores of society are contained within the costs of the firm deserves some explanation. What Primeaux and Stieber had in mind is the concept of opportunity cost. They deserves that managers “are aware (and if not, should be aware) that opportunity costs can be significant for any decision”. Legal and ethical considerations are a part of such opportunity costs. Thus, businesses face the prospects of losing customers or being saddled with litigation expenses, payments for damages, and fines if their managers make decisions that violate community standards. A real-world example that Primeaux and Stieber offered was the case of General Motors (GM) having chosen to install Chevrolet engines in Oldsmobiles produced in 1977. To GM, this seemed a reasonable efficiency move, but the company any miscalculated the cost of public indignation, bad publicity, customer compensation, legal expenses that, when all was said and done proved to be some of the opportunity cost of its decision. (GM offered a cash settlement to the affected car buyers and, of course, had to bear substantial legal expenses and suffer monumental loss of customer goodwill). A more startling case not discussed by Primeaux and Stieber was that of the Ford Pinto gas tank shield. In that instance, Ford managers actually were aware that deletion of shield from the gas tank area of the subcompact Pinto would lead to horrible injuries and numerous deaths from fiery explosions that would occur if the car were to be struck from behind. However, they calculated that the costs to the firm in litigation and damages expenses would be outweighed by the savings in the production costs of the cars. It would be easy argue that this was a calculations so terrible that it should never have been made. But other cases are less clear cut. For example, should all cars have side impact air bags and antilock brakes? Or should automakers have installed passenger-side air bags when they apparently did have some knowledge that the bags could injure or kill children placed, with or without infect safety seats, in the front passenger area? While managers who are behaving properly when they make profit-maximizing decisions certainly should try to take into account the ethics-related opportunity costs of those decisions, it is likely that in many cases imperfect information will lead to miscalculations. In addition, there will always be some managers who see opportunities to profit from decision that wrongfully harm some members of society but are mot likely to affect the firm’s bottom line because of the inability of the parties who are negatively affected to obtain redress. However, none of this is reason to condemn profit- maximizing behavior in general. As Primeaux and Stieber stressed, when properly carried out, profit maximization demands that the ethics and mores of the community become integral to the decision-making process.
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