In economics, profit maximization is the short run or long run process by which a firm determines

the price and output level that returns the greatest profit. There are several approaches to this problem.
The total revenuetotal cost perspective relies on the fact that profit equals revenue minus cost and
focuses on maximizing this difference, and themarginal revenuemarginal cost perspective is based on
the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.
Contents
[hide
! "asic definitions
# Total revenue $ total cost perspective
% &arginal revenue$marginal cost perspective
' (ase in which maximizing revenue is equivalent
) (hanges in total costs and profit maximization
* &ar+up pricing
, &arginal product of labor, marginal revenue product of labor, and profit maximization
- .ee also
/ 0otes
!1 2eferences
!! 3xternal lin+s
"asic definitions
4ny costs incurred by a firm may be classed into two groups5 fixed costs and variable costs. 6ixed costs,
which occur only in the short run, are incurred by the business at any level of output, including zero
output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be
increased or decreased in the short run, and general up+eep. 7ariable costs change with the level of
output, increasing as more product is generated. &aterials consumed during production often have the
largest impact on this category, which also includes the wages of employees who can be hired and laid off
in the span of time 8long run or short run9 under consideration. 6ixed cost and variable cost, combined,
equal total cost.
2evenue is the amount of money that a company receives from its normal business activities, usually
from the sale of goods and services 8as opposed to monies from security sales such as equity shares or
debt issuances9.
&arginal cost and revenue, depending on whether the calculus approach is ta+en or not, are defined as
either the change in cost or revenue as each additional unit is produced, or the derivative of cost or
revenue with respect to the quantity of output. 6or instance, ta+ing the first definition, if it costs a firm
'11 :.; to produce ) units and '-1 :.; to produce *, the marginal cost of the sixth unit is -1 dollars.
Total revenue $ total cost perspective
<rofit &aximization using the totals approach
To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue
8T29 minus total cost 8T(9. =iven a table of costs and revenues at each quantity, we can either compute
equations or plot the data directly on a graph. The profit$maximizing output is the one at which this
difference reaches its maximum. In the accompanying diagram, the linear total revenue curve represents
the case in which the firm is a perfect competitor in the goods mar+et, and thus cannot set its own selling
price. The profit$maximizing output level is represented as the one at which total revenue is the height of
( and total cost is the height of "> the maximal profit is measured as (". This output level is also the one
at which the total profit curve is at its maximum.
If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output mar+et, the
price to sell the product at can be read off the demand curve at the firm?s optimal quantity of output.
&arginal revenue$marginal cost perspective
<rofit maximization using the marginal approach
4n alternative perspective relies on the relationship that, for each unit sold, marginal profit 8&@9 equals
marginal revenue 8&29 minus marginal cost 8&(9. Then, if marginal revenue is greater than marginal cost
at some level of output, marginal profit is positive and thus a greater quantity should be produced, and if
marginal revenue is less than marginal cost, marginal profit is negative and a lesser quantity should be
produced. 4t the output level at which marginal revenue equals marginal cost, marginal profit is zero and
this quantity is the one that maximizes profit.
[!
.ince total profit increases when marginal profit is positive
and total profit decreases when marginal profit is negative, it must reach a maximum where marginal
profit is zero $ or where marginal cost equals marginal revenue $ and where lower or higher output levels
give lower profit levels.
[!
In calculus terms, the correct intersection of &( and &2 will occur when5
[!
The intersection of &2 and &( is shown in the next diagram as point 4. If the industry is perfectly
competitive 8as is assumed in the diagram9, the firm faces a demand curve 8;9 that is identical to its
marginal revenue curve 8&29, and this is a horizontal line at a price determined by industry supply
and demand. 4verage total costs are represented by curve 4T(. Total economic profit are
represented by the area of the rectangle <4"(. The optimum quantity 8A9 is the same as the
optimum quantity in the first diagram.
If the firm is operating in a non$competitive mar+et, changes would have to be made to the diagrams.
6or example, the marginal revenue curve would have a negative gradient, due to the overall mar+et
demand curve. In a non$competitive environment, more complicated profit maximization solutions
involve the use of game theory.
(ase in which maximizing revenue is equivalent
In some cases a firm?s demand and cost conditions are such that marginal profits are greater than
zero for all levels of production up to a certain maximum.
[#
In this case marginal profit plunges to zero
immediately after that maximum is reached> hence the &@ B 1 rule implies that output should be
produced at the maximum level, which also happens to be the level that maximizes revenue.
[#
In
other words the profit maximizing quantity and price can be determined by setting marginal revenue
equal to zero, which occurs at the maximal level of output. &arginal revenue equals zero when the
total revenue curve has reached its maximum value. 4n example would be a scheduled airline flight.
The marginal costs of flying one more passenger on the flight are negligible until all the seats are
filled. The airline would maximize profit by filling all the seats.
(hanges in total costs and profit maximization
4 firm maximizes profit by operating where marginal revenue equal marginal costs. 4 change in fixed
costs has no effect on the profit maximizing output or price.
[%
The firm merely treats short term fixed
costs as sun+ costs and continues to operate as before.
['
This can be confirmed graphically. :sing
the diagram illustrating the total costtotal revenue perspective, the firm maximizes profit at the point
where the slopes of the total cost line and total revenue line are equal.
[#
4n increase in fixed cost
would cause the total cost curve to shift up by the amount of the change.
[#
There would be no effect
on the total revenue curve or the shape of the total cost curve. (onsequently, the profit maximizing
point would remain the same. This point can also be illustrated using the diagram for the marginal
revenuemarginal cost perspective. 4 change in fixed cost would have no effect on the position or
shape of these curves.
[#
&ar+up pricing
In addition to using methods to determine a firm?s optimal level of output, a firm that is not perfectly
competitive can equivalently set price to maximize profit 8since setting price along a given demand
curve involves pic+ing a preferred point on that curve, which is equivalent to pic+ing a preferred
quantity to produce and sell9. The profit maximization conditions can be expressed in a Cmore easily
applicableC form or rule of thumb than the above perspectives use.
[)
The first step is to rewrite the
expression for marginal revenue as &2 B DT2EDA B8<DAFAD<9EDAB<FAD<EDA, where < and A
refer to the midpoints between the old and new values of price and quantity respectively.
[)
The
marginal revenue from an Cincremental unit of quantityC has two parts5 first, the revenue the firm gains
from selling the additional units or <DA. The additional units are called the marginal units.
[*
<roducing
one extra unit and selling it at price < brings in revenue of <. &oreover, one must consider Cthe
revenue the firm loses on the units it could have sold at the higher priceC
[*
Gthat is, if the price of all
units had not been pulled down by the effort to sell more units. These units that have lost revenue are
called the infra$marginal units.
[*
That is, selling the extra unit results in a small drop in price which
reduces the revenue for all units sold by the amount A8D<EDA9. Thus &2 B < F A8D<EDA9 B < F<
8AE<988D<EDA9 B < F <E8<3;9, where <3; is the price elasticity of demand characterizing the demand
curve of the firms? customers, which is negative. Then setting &( B &2 gives &( B < F <E<3; so 8<
$ &(9E< B $ !E<3; and < B &(E[! F 8!E<3;9. Thus the optimal mar+up rule is5
8< $ &(9E< B !E 8$ <3;9
or
< B [<3;E8! F <3;9H&(.
[,[-
In words, the rule is that the size of the mar+up is inversely related to the price elasticity
of demand for the good.
[,
The optimal mar+up rule also implies that a non$competitive firm will produce on the
elastic region of its mar+et demand curve. &arginal cost is positive. The term <3;E
8!F<3;9 would be positive so <I1 only if <3; is between $! and $ Gthat is, if demand
is elastic at that level of output.
[/
The intuition behind this result is that, if demand is
inelastic at some value A! then a decrease in A would increase < more than
proportionately, thereby increasing revenue <A> since lower A would also lead to lower
total cost, profit would go up due to the combination of increased revenue and
decreased cost. Thus A! does not give the highest possible profit.
&arginal product of labor, marginal revenue product of labor,
and profit maximization
The general rule is that firm maximizes profit by producing that quantity of output where
marginal revenue equals marginal costs. The profit maximization issue can also be
approached from the input side. That is, what is the profit maximizing usage of the
variable inputJ
[!1
To maximize profit the firm should increase usage of the input Cup to
the point where the input?s marginal revenue product equals its marginal costsC.
[!!
.o
mathematically the profit maximizing rule is &2<K B &(K, where the subscript K refers to
the commonly assumed variable input, labor. The marginal revenue product is the
change in total revenue per unit change in the variable input. That is &2<K B DT2EDK.
&2<K is the product of marginal revenue and the marginal product of labor or &2<K B
&2 x &<K.
Kong run and short run
6rom Li+ipedia, the free encyclopedia
82edirected from .hort run9
"Long run" redirects here. For other uses, see Longrun (disambiguation).
In microeconomics, the long run is the conceptual time period in which there are no fixed factors of
production as to changing the output level by changing the capital stoc+ or by entering or leaving an industry.
The long run contrasts with the short run, in which some factors are variable and others are fixed, constraining
entry or exit from an industry. Inmacroeconomics, the long run is the period when the general price level,
contractual wage rates, and expectations adMust fully to the state of the economy, in contrast to the short run
when these variables may not fully adMust.
[!
Contents
[hide]
1 Long run
2 Short run
3 Transition from short run to
long run
4 The law of diminishing
marginal returns
5 Macroeconomic usages
6 See also
!ootnotes
" #eferences
[edit]Long run
In the long run, firms change production levels in response to 8expected9 economic profits or losses, and
the land, labor, capital goods and entrepreneurship vary to reach associated long$run average cost. In the
simplified case of plant capacity as the only fixed factor, a generic firm can ma+e these changes in the long run5
enter an industry in response to 8expected9 profits
leave an industry in response to losses
increase its plant in response to profits
decrease its plant in response to losses.
Kong$run average$cost curve with economies of scale to Q2 and diseconomies of scale thereafter.
The long run is associated with the long$run average cost 8K24(9 curve in microeconomic models along which
a firm would minimize itsaverage cost 8cost per unit9 for each respective long$run quantity of output. Long-run
marginal cost 8LRMC9 is the added cost of providing an additional unit of service or commodity from changing
capacity level to reach the lowest cost associated with that extra output. K2&( equalling price is efficient as
to resource allocation in the long run. The concept of long-run cost is also used in determining whether the
long$run expected to induce the firm to remain in the industry or shut down production there. In long$run
equilibrium of an industry in which perfect competition prevails, the K2&( B Long run average LRAC at the
minimum LRAC and associated output. he shape o! the long-run marginal and average costs curves is
determined b" economies o! scale.
The long run is a planning and implementation stage.
[#[%
Nere a firm may decide that it needs to produce on a
larger scale by building a new plant or adding a production line. The firm may decide that new technology
should be incorporated into its production process. The firm thus considers all its long$run production options
and selects the optimal combination of inputs and technology for its long$run purposes.
['
The optimal
combination of inputs is the least$cost combination of inputs for desired level of output when all inputs are
variable.
[%
Once the decisions are made and implemented and production begins, the firm is operating in the
short run with fixed and variable inputs.
[%[)
[edit]Short run
4ll production in real time occurs in the short run. The short run is the conceptual time period in which at least
one factor of production is fixed in amount and others are variable in amount. (osts that are fixed, say from
existing plant size, have no impact on a firm?s short$run decisions, since only variable costs and revenues affect
short$run profits. .uch fixed costs raise the associated short$run average cost of an output leveong$run
average cost if the amount of the fixed factor is better suited for a different output level. In the short run, a firm
can raise output by increasing the amount of the variable factor8s9, say labor through overtime.
4 generic firm already producing in an industry can ma+e three changes in the short run as a response to reach
a posited equilibrium5
increase production
decrease production
shut down.
In the short run, a profit$maximizing firm will5
increase production if marginal cost is less than marginal revenue 8added revenue per additional unit
of output>
decrease production if marginal cost is greater than marginal revenue>
continue producing if average variable cost is less than price per unit, even if average total cost is
greater than price>
shut down if average variable cost is greater than price at each level of output.
[edit]Transition from short run to long run
The transition from the short run to the long run may be done by considering some short$run equilibrium that is
also a long$run equilibrium as to supply and demand, then comparing that state against a new short$run and
long$run equilibrium state from a change that disturbs equilibrium, say in the sales$tax rate, tracing out the
short$run adMustment first, then the long$run adMustment. 3ach is an example of comparative statics. 4lfred
&arshall 8!-/19 pioneered in comparative$static period analysis.
[*
Ne distinguished between the temporary or
mar+et period 8with output fixed9, the short period, and the long period. C(lassicC contemporary graphical and
formal treatments include those of Pacob 7iner 8!/%!9,
[,
Pohn Nic+s8!/%/9,
[-
and <aul .amuelson 8!/',9.
[/
[edit]The law of diminishing marginal returns
The law of diminishing marginal returns to a variable factor applies to the short run.
[!1
It posits an effect of
decreased added or marginal product of from variable factors, which increases the supply price of added
output.
[!!
The law is related to a positive slope of the short$run marginal$cost curve.
[!#
[edit]Macroeconomic usages
The usage of ?long run? and ?short run? in macroeconomics differs somewhat from the above microeconomic
usage. P.&. Qeynes 8!/%*9 emphasized fundamental factors of a mar+et economy that might result in
prolonged periods away from full$employment.
[!%
In later macro usage, the long run is the period in which
the price level for the econom" is completely flexible as to shifts in aggregate demand and aggregate suppl". In
addition there is full mobility of labor and capital between sectors of the economy and full capital mobility
between nations. In the short run none of these conditions need fully hold. The price is stic+y or fixed as to
changes in aggregate demand or supply, capital is not fully mobile between sectors, and capital is not fully
mobile to interest rate differences among countries R fixed exchange rates.
[!'
4 famous critique of neglecting short$run analysis was by Pohn &aynard Qeynes, who wrote that C#n the long
run, $e are all dead,C referring to the long$run proposition of thequantity theory of, for example, a doubling of
the money supply doubling the price level.
[!)