No Free Lunch: Economics for A Fallen World

7 | Production: Man At Work

Profit Maximization

Given our assumption of profit maximization, we need to understand how an entrepreneur actually produces to maximize profit. Earlier we defined total profit as the difference between total revenues and total costs:

Higher-level mathematics and economics classes teach how to maximize any function using calculus. However, we will illustrate profit maximization graphically in Figure 7.10. By plotting a total revenue line (which is just the price of a product multiplied by its quantity) along with a total cost curve, we can see where an entrepreneur will suffer losses or gain profits. We can see that lower levels of output (below Q1) will result in losses for our entrepreneur, as total costs exceed total revenues. In this area of production, the gains from specialization and division of labor have not materialized. In the area between Q1 and Q2, the entrepreneur will accrue those gains and total revenues will exceed total costs such that he or she will achieve a profit. The greatest distance between TR and TC occurs at Q* and is the profit maximizing output level. Further output will result in lower profit, and if output goes beyond Q2 the entrepreneur will suffer losses as diminishing returns lower production efficiency. Figure 7.10, Profit Maximization. Since total revenues (TR) are simply the product of price (P) and quantity (Q), TR is a straight line beginning at the origin. With quantities below Q1 or greater than Q2, total costs exceed total revenues: the entrepreneur will suffer losses if he/she produces at that level. Anywhere between Q1 and Q2 will result in a profit. The greatest distance between total revenues and total costs occurs at Q* and is the profit maximizing quantity our entrepreneur should produce.

Taking this down one level, an entrepreneur would want to produce an additional unit of output as long as the marginal revenue from that unit is greater than the marginal cost. For competitive markets, the marginal revenue is just the price of the product. Profit maximization will occur at Q* where MR=MC as seen in Figure 7.11. An entrepreneur needs to think on the margin, just like the rest of us! Figure 7.11, Profit Max at MR=MC. In a purely competitive market, the marginal revenue simply equals the price. If an entrepreneur produces one more unit of output, he or she will be able to sell at the market price so the marginal revenue curve is a horizontal line. To maximize profit, the entrepreneur should expand output until the marginal cost curve exceeds the marginal revenue curve. Profit is maximized where marginal costs equal marginal revenues.

When an entrepreneur is maximizing profit, he or she will choose the best combination of inputs that produce both effectively and efficiently. We say that an entrepreneur or firm is technologically efficient if it is not possible to increase output without increasing inputs. Our entrepreneur in this case is getting everything out of the scarce resources possible. He may produce a given output with a lot of capital equipment and very little (but highly specialized) labor. Or he may choose the opposite. The flip side of the same coin is that he must also be economically efficient. With economic efficiency, a given output is produced with the lowest cost combination of resource inputs. Some entrepreneurs may find it less costly to have more labor and less capital equipment, while others may be just the opposite. Profit maximization will require them to find out that precise combination of inputs that minimizes costs for a given output. If an entrepreneur is technologically and economically efficient, and produces at marginal revenue equaling marginal costs, he will maximize profits.

If an entrepreneur is maximizing profit, he or she is satisfying consumer demand while using the least amount of scarce economic resources. That leaves more land, labor, capital, and entrepreneurship available to support other consumer desires. Profit maximization by an individual firm in a competitive market is therefore a necessary condition to maximize social welfare. When a firm is profit maximizing, they are not only directly serving us by producing a product we want to buy, but they are indirectly serving us by freeing up scarce resources which can be used to produce other goods we want to consume.

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