Market Structures Essay

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PROFIT MAXIMISATION Profit is the difference between total revenue and total cost ie [pic], where [pic]represents profit, TR total revenue and TC total cost. As total revenue is the income to the firm from the sale of its output, it is calculated by multiplying price (or average revenue) by the number of units sold (or quantity). Therefore TR=P*Q where P is the price and Q the quantity. We assume that firms aim at maximizing profits, but how does a firm achieve profit maximization? This can be answered using the concepts of marginal cost (MC) and marginal revenue (MR). MC is the change in total cost results from increasing output by one unit. MR is the change in total revenue resulting from a unit change in output. The MR curve is derived from a firms’ average revenue or demand curve. Assume that the firm faces a downward slopping demand curve, the firm will also face a downward slopping MR curve. [pic] At output level OQ[pic], the firm is not maximising profits as MR is higher than MC. By producing an additional unit, the firm will add more to its’ revenue than to costs, and profit will increase. The firm should increase output. At output level OQ[pic], MC is greater than MR. An additional unit of output results in a reduction in the firms’ profits. By producing less the firm can reduce costs more than revenue. To maximize profit the firm should produce that quantity of output at which MR and MC are equal (OQ[pic]). [pic] Consider a situation where the MC curve cuts the MR curve twice. At output level OQ[pic], the firm can increase profits by increasing output as the MR of an additional unit is greater than the MC. Output OQ[pic] is therefore not the profit maximizing output. At output level OQ[pic], if the firm reduced output to OQ[pic]profits would fall as MR is greater than MC. The profit maximizing output is OQ[pic] where the MC curve is rising and cuts the MR

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