Cambridge International as and a level Economics Ebook

Diff ering objectives of a firm
Profit maximisation
We saw earlier how the profi t earned by a fi rm is referred 
to as normal profi t and abnormal profi t. Th
e standard 
assumption made by economists, as made clear in our 
analysis of market structures, is that fi rms will seek
 
to 
maximise their profi ts, i.e., maximise the diff erence 
between the total revenue and total cost (including normal 
profi t). A fi rm making the minimum level of normal 
profi t is said to be producing at the break-even output. No 
abnormal profi t is being made. Most fi rms, though, will 
want to make abnormal profi t as a reward for taking risks.
If the fi rm produces up to the point where the cost of 
making the last unit is just covered by the revenue from 
selling it, then the profi t margin will have fallen to zero and 
total profi ts will be at their greatest. In 
Figure 7.23
, a fi rm 
producing an output to the left of 
Q 
is sacrifi cing potential 
profi t. It can raise total profi t by increasing its output, 
because each further unit sold adds more to revenue than it 
does to costs. A fi rm producing to the right of 
Q
is making 
a loss on each successive unit, which will lower the total 
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Cambridge International A Level Economics

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profi t. It would be better off cutting output back to 
Q
where 
MC 
=
MR and the area of abnormal profi t will be maximised.
Th
ere may be several reasons why fi rms do not operate 
at the profi t maximisation output:
■ 
In practice, it is diff icult to identify this output. The firm may 
simply work out the average total cost and then add on a 
standard profit margin in order to determine the selling 
price. This cost-plus pricing technique may not result in 
maximum profit.
■ 
Short-term profit maximisation may not be in the long-term 
interest of the company since:
❏ 
firms with large market shares may wish to avoid the 
attention of government watchdog bodies, such as the 
Competition and Markets Authority in the UK and the 
US Justice Department
❏ 
large abnormal profit may attract new entrants into 
the industry
❏ 
high profits may damage the relationship between the 
firm and its stakeholders, such as its consumers and the 
company workforce as they may see senior managers 
and shareholders earning large returns
❏ 
profit maximisation may not appeal to the management, 
who may have diff erent objectives – high profits might 
trigger action by the firm’s rivals and it could become a 
target for a takeover bid.