Rules for maximising profit

    The profit-maximisation assumption is important, because it has strong implications for how firms behave. These implications apply both to the pricing decision and to the output decision. Where competition is intense, the firm has little

or no discretion over price. It takes price as given. The key decision becomes how

much to produce. The company must also decide what techniques to use in

its production: how much labour, what type of machinery, buildings and raw

materials. In making these decisions, a profit-maximising firm will be guided by

certain rules.

    A first rule is that a technically inefficient production technique should not be used. If 100 units of output could be produced by using 80 units of labour and 100 units of capital, or 60 units of labour and 90 units of capital, technique will always be chosen by the profit maximiser. This profit maximisation objective dictates that the firm will seek out best practice technologies and avoid waste.

    Second, the firm minimises the cost of producing any given level of output. It minimizes costs by applying the rule: purchase each input up to the point where the net value of the output produced by that input equals the cost to the firm of purchasing it. The input might be the services of an employee, a new machine, additional quantities of raw materials or more warehousing space. The marginal cost of the input to the firm is the price paid . The value of the extra output produced by each input to the firm equals the extra output multiplied by price .

    Suppose this were not the case. Say the value of the marginal product of an

employee is £100 per day (net of material costs), while the cost of hiring him or

her is £60 per day. At the same time, the marginal product of the new machine is

£60, but the cost of running it is £100 per day. Then, assuming no other costs, the

firm is making £40 per day profit from the marginal employee and losing £40 per

day from the marginal machine. The profit-maximising firm should hire more

labour and fewer machines!

    The third rule is that the firm must produce up to the point where marginal

revenue equals marginal cost. Recall from Chapter 4 that marginal

revenue equals the increase in total revenue derived from the sale of one additional

unit. Marginal cost is defined analogously as the increase in total cost

incurred by the production of one additional unit. Suppose the marginal revenue

from an additional unit of sales is £10 and marginal cost is only £5. Clearly, it is profitable for the firm to produce that unit. Suppose that the next unit also earns a marginal revenue of £10 but that its marginal cost rises to £8. It is profitable to produce that unit also. The firm will increase production up to the level where the marginal cost and the marginal revenue are equal. At any lower output, marginal revenue exceeds marginal cost and unexploited opportunities for profit would be ignored. At any higher output,marginal cost exceeds marginal revenue. The firm incurs losses at the margin, and that too is inconsistent with profit maximisation.