1. MR=MC
The optimising condition
(or how do firms maximise profit?)

2. Lets go make Evaluation
What shall we a profit!
do today,
Sam?
There are two
alternatives to this view
of a firms' objectives.
Managerial Theories are
based on the assumption
that the firm will pursue
objectives that are in the
interest of the managers
– after all, they are in
charge! Managers may
What is the purpose of a firm? pursue career
advancement, company
Most economic theory is based on the idea that all economic growth or the
agents act in their rational self-interest to maximise their achievement of bonuses.
utility. Organisational theories
emphasise the
In plain English this means that we assume people earn as competing needs of
much as possible to be able to buy what they want, that stakeholders and the
governments aim to increase wealth and wellbeing in the nation conflict between these
and that businesses try to make as much profit as possible. objectives. This conflict
results in compromise,
perhaps accepting less
The idea that firms profit maximise is a fundamental
than maximum profit in
assumption underpinning the neo-classical Theory of the return for better working
Firm. conditions for employees.

3. Hmmm... how do I make the maximum
profit?
I know that profit is the difference between
my revenue and the total cost of making the
products, so...
Total profit = Total Revenue – Total Cost
But how many products do I have to make
to get the biggest difference between
revenue and costs?
Not sure, but what I do know is if I can sell Alfred isn't a genius but he
more than I do now at a profit then I should can work out that he needs to
increase production. But if I have to reduce
price so much to sell more that these
sell as many products as
products make a loss then I shouldn't possible as long as each
increase output. one he sells adds to the
profit of the business. This
is known as the optimising
condition.

4. The Alfred test
Alfred's business is making 1000 products a week. Should he increase production to 1001? Here are
the facts...
To sell the 1001st product Total Revenue would increase by £5.00
Total Cost would increase by £4.80
What should Alfred do?
Susan's bright idea
Susan is the Production Manager for the business. She has a bright idea. The business has enough
equipment to produce 1100 products a week. Susan thinks they should make good use of the firm's
capacity by increasing production to this level.
To increase sales to 1100 products the total revenue would increase by £200
The Total Costs would increase by £240
Should Alfred accept Susan's suggestion?

5. Alfred's dilemma leads us to two common sense conclusions;
1. Don't increase output unless your profit increases
2. Decrease your output if you could make more profit
In other words, produce at the level at which you profit maximise.
Without realising it, Alfred is using the concepts of
marginal revenue (MR) and marginal cost (MC) to
make his decision. Marginal revenue is the additional If firms behave in their
revenue received by the firm for increasing output by rational self-interest they
one unit. Marginal cost is the additional cost added by will reach an equilibrium
supplying one more unit. level of output whereby
marginal revenue equals
In the example, MR of the 1001st unit is £5.00 and MC marginal cost, or
is £4.80. Therefore the firm can increase its profit by where...
increasing output. We can express the conclusions
above by using 'marginal language'.
Where MR>MC the firm should increase output MR=MC
Where MR<MC the firm should decrease output

6. COMMON MISTAKE ALERT
Marginal revenue is not the same as the price charged for the next
product. To sell an extra product it may be necessary to reduce the price
of all products (if the firm can't price discriminate), therefore the firm will
gain the revenue of selling another product but lose the revenue of
reducing prices overall. The same goes for costs. By making more
products the average cost of producing each product may fall. Therefore
the marginal cost is the overall increase or decreases in total costs.
WARNING – DODGY ASSUMPTION!
The belief that firms behave in this way is underpinned by the assumption
that firms understand the behaviour of revenue and costs in their
business. In other words it assumes perfect information on behalf of
the firm. In reality it is very difficult to calculate the optimal level of
production. The market price may change frequently, costs may fluctuate,
productivity varies from day to day and the firm may be charging different
prices to different customers.
BEWARE THE WEIRD DEFINITION
Why would a firm produce an extra product if the additional revenue (MR)
would be equal to the additional cost (MC)? In other words, why produce
that extra product if there is not extra profit to be gained? To understand
the reason for wanting to produce a product where MR=MC we need to
understand that the economists definition of 'total cost' includes a level of
'normal profit'. The 'cost' of production includes the 'cost' of
rewarding the investor for placing their capital in the business.

7. Normal versus Supernormal
Normal profit is the minimum level of profit
necessary to keep firms in the market. Without
a minimal level of profit investors will withdraw
their funds and place them instead in a market
which offers better returns.
However, as normal profit is so unimpressive
new firms will not be attracted into the market.
Economists consider normal profit to be a cost
of production as it is the cost of keeping
investors interested.
Supernormal profit (also known as abnormal or
above-normal profit) is enough to attract new
firms into the market. New firms will take a
share of these profits and eventually all firms
will tend towards a normal level of profit.
Evaluation
How close is this theory to what actually happens? Do all firms in all markets make 'normal profits'?
The theory assumes perfect knowledge on behalf of investors about the profits available. It also
assumes no barriers to entry into markets where supernormal profit is available. Remember the
Theory of the Firm is a neo-classical theory. This means it is built on assumptions about how
'perfectly competitive' markets operate.

8. You can't do economics without a diagram...
Now it's time to apply the theory. We have learnt that to maximise profit a firm should
apply the MR=MC optimising condition. By examining a firms revenue and cost structure
we should be able to predict what level of output the firm will tend towards.
We will model the effect of these rules in a perfectly competitive market. In this type of
market it is assumed that the individual firm has to set the ruling market price and therefore
its demand curve is perfectly elastic. We also assume that the average and marginal costs
of production falls at low levels of output due to increasing marginal returns and increases
as diminishing marginal returns take effect. The model looks like this...
The firm's output is
determined by the
MR=MC rule.
At this level of output the
profit is represented by the
shaded area.
The profit is the difference
between the average
revenue and average
cost, multiplied by the
Graphic courtesy of Tutor2u
level of output.

9. Can this supernormal profit be sustained in the long run?
In a perfectly competitive market new firms are free to enter or leave the market. The
supernormal profit will act as a signal to firms who will respond to this incentive by entering
the market. The increase in supply in the market (represented by a shift to the right in the
market diagram below) pushes down the equilibrium price. The individual firm must take
this ruling market price (remember we assume that consumers choose only the cheapest
good and have perfect knowledge of the prices charged by firms). The firm's revenue
curve shifts downwards until MR=MC=AC. The firm is making a normal profit and this
signals that there are no excess profits remaining and no more firms will enter the market.
The firm's output is
still determined by
the MR=MC rule.
However, at the new
price level the firm's
total revenue equals
its total cost.
Therefore it only
makes a 'normal'
profit.

10. Summary
THE OPTIMISING CONDITION USING THE THEORY

Firms aim to maximise profit 
We can use this knowledge to work out what

This is achieved where at the output level of output a firm should set to maximise
where the difference between total revenue profit
and total costs is at its greatest 
We can also examine the behaviour of a

Or where Marginal Revenue equals market to see whether firms in the market are
Marginal Cost (MR=MC) behaving in their rational self interest i.e.
producing at a level which will maximise profit

Knowing how firms 'should' behave in a
APPLYING THE THEORY perfectly competitive market we can look for

Firms should produce a level of output evidence of what actually happens and draw
where MR=MC conclusions about how close to the model of

The profit at this level of output is perfect competition the market actually is
determined by the difference between
Average Revenue and Average Cost
multiplied by the level of output QUESTIONNING THE THEORY

In a perfectly competitive market firms 
Do firms always pursue a profit maximising
may make supernormal profits in the short objective?
run if there are too few firms in the market 
Do firms possess sufficient information to make

In the long run the supernormal profit rational decisions about their output?
signals to firms to enter the market which 
Do real-world markets ever meet the conditions
reduces profit levels to 'normal' of perfect competition?