7 PROFIT MAXIMISATION

Syllabus
Profit maximisation Producer's equilibrium - Shutdown Condition

Subject-matter of the Chapter

In the traditional theory it is assumed that the objective of the firm is to
maximise total profit which is defined as the difference between total revenue
and total cost. In this chapter we shall first consider different concepts andd
elements of profit. Then we shall derive the conditions of profit maximisation.
Lastly we shall consider some limitations of the profit maximisation hypothesis.

1.1, THE CONCEPT OF PROFIT

We know that there are four factors of production: land, labour, capital and
organisation or entrepreneur. The main task ofthe entrepreneur is to organise
the production process. The entrepreneur hires other factors of production and
makes arrangement for the production of goods and services. By selling goods
and services in the market the entrepreneur gets his total revenue. When
entrepreneur hires other factors of production, the payments to be made to
other factors of production are fixed by contract. The amount of money required
The
todifference between total revenue and total
hire other factors of production is called the total
cost of production.
cost is called the profit. If total revenue
is greater than total cost, profit is positive. On the other hand, if total revenue is
less than total cost, profit is negative. This means that the entrepreneur suffers
a loss. Thus profit is a residual income. Other factor incomes are contractually

fixed but profit is not contractually fixed. After paying other factors of production,
the residue which remains is the profit. This profit is the income ofthe organiser.
the owner
If the organisation is a proprietorship or sole ownership concern,
concern, the profit is distributed
alone gets this prof+t. If it is a partnership
stock company, the profit is distributed among
among the
partners. Ifit is
a joint
the share-holders as dividend.
7.1.1. Gross Profit and Net Profit
The difference between total revenue is called gross profit. In
and total cost
to
words, the difference between total revenue and total payments made
other Thus,
other factors of production hired by the entrepreneur is called gross profit.
revenue and total
contractual cost.
gross profit is the difference between total
But sometimes it is found that some factors of production are employed n tne

himself. For example,

production process which are owned by the entrepreneur
91
 92Higher Secondary Economics
the plot of land on which production takes place may be owned by the entrepreneur
services. The
himselt. Again, the entrepreneur may also provide labour
In this
entrepreneur may also employ his own capital in the production process.
case, the gross profit includes the rent of the land owned by the entrepreneur or
the wage for the services rendered by the entrepreneur or the interest of capital
owned by the entrepreneur. Thus, if from gross profit we deduct the payments
we
to be made on account of factors of production supplied by the entrepreneur,
can get net profit. the
When an entrepreneur hires a plot of land owned by another individual,
worker in
engages a
rent is fixed by contract. Similarly, when the entrepreneur
contract. If the
entrepreneur borrows
lieu of wages, the wages a r e fixed by
the entrepreneur
contract. But when
Tunds, the rate of interest is also fixed by i n the
services or his own capital
employs his own land or his own labour therefore, is
process, no such agreement
takes place. The question,
production entrepreneur or the wages
how can we determine the rent of land owned by the the
or the interest
on capital
for labour services supplied by the entrepreneur
it c a n be said
a n s w e r to this question
funds provided by the entrepreneur ? In
he could have obtained
that if the entrepreneur leased his land to another person,
of land owned by
a rent. That rent will have to be
taken a s the rent on the plot
Similarly, had the
process.
the entrepreneur and used in the production
have obtained certain wages which
entrepreneur worked elsewhere, he could
the entrepreneur in
should be taken as the value of labour services supplied by
the production process. In the s a m e way, had
the entrepreneur lent his capital
interest. That interest should
funds to other individuals, he could have obtained
on the funds supplied by the
be taken to determine the rate of interest
of production which are supplied
entrepreneur. This type of earnings of factors
or imputed costs. If this
by the entrepreneur is known as implicit earnings net profit. If gross
implicit earning is deducted from gross profit, we can get
zero. If gross profit is greater than
profit is equal to implicit earning, net profit is
other hand, if gross profit is less
implicit earning, net profit is positive. On the
than implicit earning, net profit is negative. Gross profit is thus always greater
than or equal to net profit.
7.1.2 Elements of Profit
According to Professor Taussig, profit is a mixed and vexed income. There are
several elements of profit. We know that the difference between the total revenue
and total contractual cost is the gross profñt of the entrepreneur. From this gross
profit if we deduct the payments to factors of production which are owned by the
entrepreneur himself, we can get net profit. The net profit has certain elements.
Let us now discuss the elements of net profit.
First, net profit is the reward for risk-taking. The entrepreneur has to take
risk in organising the produetion process. Profit may be positive or negative. There
1sno guarantee that the goods produced by him will be sold in the market. Hence
when a certain amount of money is spent to produce goods and services, there is a
risk involved. The reward for risk- taking is profit. Professor Knight has
distinguished between risk and uncertainty. By risk he means a situation where
the occurrence of different events can be
predicted with definite probabilities. But
 Profie Maximlsatlon 93
uncertan event is an
event wh08e
nreneur bears not only risk but also probability not be calculated. The
canno
r uncertainty. The reward for uncertainty. No other factor of production
eni
profit.
uncertainty-bearing i8 also an element of net
P Secondly, profit can alaso arise as a result of innovation. The
an innovate a new product or a new process of production. He
entrepreneur
can als0 capture a
mew market. For al these reasons the
entrepreneur can increase his profit. This
ypedof profit may be regarded as a reward for innovation. It is also another
element
of net profit.
Thirdly, if the entrepreneur enjoys monopoly power in the market, he can
earn excess profit. The monopoly firm can earn more than normal profit. In an
imperfectly
np competitive market, the monopolist can earn excess profit through
patents, oopyrights, business combinations, etc. The profit which arises as a result
of imperfection in the market is called monopoly profit. This is also an element of
net profit.
Fourthly, the firm can also increase its net profit through product
differentiation. Under monopolistic competition, different firms produce
differentiated products. The product of each firm is different from the products
of other firms either in brand or in packing. Due to brand preference, some
firms may earn excess profit. This is also an element of net profit.
Fifthly, another element of net profit is windfall gain. Sometimes producers
get unexpected opportunity of realising excess profit. For example, if there is a
sudden increase in demand for the commodity or if there is a sudden shortfall in
supply, the producers can earn unexpected profit. Such unexpected profit may also
arise as a result of changes in tastes and preferences of the consumers. Such
windfall profit is also another element of net profit.
7.1.3 Difference between Profit and Other Factor Incomes
In order to understand the nature of profit it is necessary to discuss the difference
between profit and other factor incomes. By other factor incomes we mean the
rent
main difference
of land, the wages of workers and the interest on capital.theThe hires
between the entrepreneur and other factor-owners is that entrepreneur
entrepreneur is an unhired factor of production.
other factors of production but the the of the entrepreneur
Dueto this difference there is a difference between earning differences can be found
the earnings of other factor-owners. The following
and
betweenprofit and other factor incomes. are used in the production process,
First, when other factors of production o w n e r s of other factors
of
contract is made between the entrepreneur and the
a made to the other factors of production
are
to be
production. The payments or interest a r e contractually
this contract. As a result, rent, wages
determined by income. It is a residual income.
After paying
contractual
hixed.But profit is not a
residue that remains represents
total profit.
of production the
otherfactors incomes cannot be zero or negative since they
are

Secondly, other factor since it i8 a residual

be zero or negative
Contractually fixed. But profit
can

income. but profit can change

do not change rapidly
other factor incomes
Thirdly, fixed by contract, such
other factors of production are
pidly. Since prices of
94HigherSecondary Economics
prices cannot change so long as the contract remains valid. It 18 only when the
contract period ends, the prices of such factors of production can be revised. But

can change rapidly. For this it is found that while other factor incomes
profit reason
do not tluctuate very much from one year to another year, profits tluctuate very

much from one year to another year.

risk element in other factor
Fourthly, even though there may be some
In fact profit is
incomes but in the case of profit the risk element is the highest.

regarded as a reward for risk-taking. There is also some

risk in providing labour
The risk of
services. For example, the labourer may be affected by an accident.
the accident can be covered by insurance. But the risk of the entrepreneur
cannot be insured.
factor incomes
Lastly, it can be said that profit is a surplus income. Other
are included in the cost of production but the entire amount
of profit 18 not
the cost
included in the cost of production. Only the normal profit is included in
which the
of production. By normal profit we mean that amount of profit without
This
entrepreneur will not come forward to undertake the production process.
normal profit is only included in the cost of production. But the whole of other
factor incomes is included in the cost of production.

7.2, ASSUMPTIONS OF PROFIT MAXIMISATION HYPOTHESIS

The classical or traditional view about the objective ofa business firm is tha
the goal of the firm is to maximise profit. This view is known as the profit
of
maximisation hypothesis. This hypothesishas been developed on the basis
consider these assumptions one by
one.
some assumptions. Let us
which uses
First, it is assumed that the firm is a producing organisation
from the market and the
inputs to produce output. The inputs are purchased
output is also sold in the market.
knows the demand function with
Secondly, it is assumed that the firm
revenue curve of the firm.
certainty. The demand curve is the average its cost function.
Thirdly, it is assumed that the firm knows with certainty
Production cost is the only cost to the firm.
that the firm is owned and managed
Fourthly, the traditionaltheory assumes
individual. The owner of the firm is known as the proprietor or the
by one
takes all the vital decisions.
entrepreneur. The entrepreneur
within a given time horizon
Fifthly, it is assumed that the firm operates
related to each other.
and different time periods of the horizon are not
Sixthly, it is also assumed that within a given time period, techniques of
assumed that tastes and preferences of the
production do not change. It is also
consumers do not change.
unlimited information, time and
Lastly, it is assumed that the firm has
actions.
ability to compare all the possible alternative
FOR PROFIT MAXIMISATION
1.3. CONDITIONS
In the traditional theory it is assumed that the objective
of the firm is to
The firm
maximize profit. The firm employs different inputs to produce output.
market. On the other hand the firm
gets revenue by selling that output in the The
has to spend money to produce output. This is known as cost of production.
firm. The
difference between total revenue and total cost is the profit of the
 Proft Maximisatlon 95
hiective of the firm is to
maximise this profit. That amount of
tota profit is maximum is
called the output for which
Todetermine the equilibrium outputequilibrium output level of the firm.
level the firm will consider additional
revenue ana adaional cost
associated with increase or decrease in the
level. Weknow that if the firm
sells one additional unit of
output
venue which the firm gets is
reve output additional
cost of
marginal revenue (MR). Similarly, additional
producing
one extra unit
of output is
marginal cost (MC). Suppose, for
producingand selling one extra unit of
output the firm gets additional revenue
of 10 and the firm's additional
cost is T 5. Then that extra unit is
to produce and sell because from that profitable
extra unit the firm gets extra profit of
(10-5) or 5. In general
for
if any unit of output
it is found that
then it is profitable to produce that unit of MR>MC,
output. Firm's total profit will
increase if that unit is produced and sold. In this
way the firm will expand
production and sale so long as MR>MC. The firm will stop at that unit where
MR=MC. At that outut level total profit will be maximum. Again if for any
unit of output it is found that MC>MR, then firm's total profit will fall if that
unit is produced and sold. The firm will not produce and sell that unit and this
will continue so long MC remains higher than MR. The firm will stop where
MR=MC which is the condition for profit maximisation.
The determination of the profit maximising output level can also be shown
with the help of a diagram. Consider the side diagram (Fig. 7.1.) where we
plot the level of output on the horizontal axis and MR and MC on the vertical
axis. Assume that the MR curve is downward-
sloping while the MC curve is upward-rising.
MR and MC curves intersect at point P where
the output level is 0Q. Hence for 0Q units of MC
output MR will be equal to MC. Therefore 0Q
can be called the equilibrium output level and
at this output level total profit will be maximum.
From the figure it is seen that if the output
level is less than OQ, then MR>MC and it is
profitable to produce more output. So the output MR

level will increase until the output level reaches Quantity of output
the level is greater than
0Q. Again if output
0Q, then MC>MR and the output level will fall Fig 7.1
towards 0Q. In this way 0Q will be the
equilibrium output level because if this output level is reached, output level
will not have any tendency to increase or decrease.
both for maximisation and
The condition MR=MC is, however, necessary
of profit one additional condition
tor minimisation of profit. For maximisation
condition is that MC curve should
should also be satisfied. This additional if
This condition is automatically fulfilled
intersect the MR curve from below. at the
MR curve is downward-sloping
and the MC c u r v e is upward-rising
the MR and MCcurves are downward-sloping
antersection point. If, however, both MR
the additional condition will be fulfilled if the
at the intersection point MR
MC curve. If the
MC curve is steeper than the
the
curve is steeper than then even if MR=MC
total profit will not be
curve at their intersection point
additional condition
will not be satisfied then.
the
XLmum at that point
a s
 Higher Secondary Economcs
SHUT DOWN CONDITION
MC and (i) MCeute
rotit maximisation requires twoconditions: (i) MR= MH
Irom below. Even if these two conditions are fulfilled there 18 no guarantee t

maximium profit will be positive. In other words when profit is maximised maxim. tha
proht may be positive, zero or negative. When profit is negative the firm is logi
Now the question is: ifa firm is losing will it continue production ? In answer
this question it can be said that if the firm is losing it will continue to produce
the short run so long as the amount of loss is less than the total fixed cost ofth
firm. But if the loss of the firm exceeds the total fixed cOst of the firm, the firm wil
not continue production in the short run.
We know that in the short run total cost has two components: total fixed co
and total variable cost. Total fixed cost is independent of the level of output andi
has to be paid even if the output level falls to zero i.e. if the firm stops production
in the short run. On the other hand variable cost varies with the level of output
As the output level increases total variable cost also increases and vice versa.
When the output level is zero, total variable cost will also be zer0.
Now suppose the total fixed cost of the firm is 7 1000 while the firm's los8 is
500. Now if the firm stops production it will have to incur a cash drain of
1000. But ifthe firm continues production it will have to incur a cash drain of
500. So the firm should continue production, even if it is losing, to minimise
the cash drain. However if the loss of the firm exceeds the total fixed cost of the
firm then the firmwill stop production because by stopping production the firm
can minimise the cash drain. Thus the shut down condition of the firm is that
loss should exceed the total fixed cost of the firm. We know that in the short
run
total cost has two components: total
variable cost and total fixed cost. Now if
total revenue exceeds total variable cost and a part of total fixed
cost, then the
uncovered portion of the fixed cost will be the loss and loss is less than
the total
fixed cost of the firm. But if total revenue cannot cover the
total variable cost,
then loss exceeds total fixed cost and
production will be stopped. Hence the shut
down condition can also be stated as : total revenue is less
than total variable
cost of the firm.

LIMITATIONS OF PROFIT MAXIMISATION HYPOTHESIS

Many objections have been raised against the profit maximisation
It is argued that the profit maximisation hypothesis
basis of some unrealistic assumptions. We
hypothesis has been developed on the
can mention of the
criticisms
some
levelled against the profit maximisation
hypothesis.
First, in the prof+t maximisation hypothesis it is assumed that the
firm is
owned by a single individual who is the owner
as well as the It was
true when the size of the firm was small. But for manager.
the organisational form i8 a joint stock
large scale business organisations
company where there is a separation of
ownership and management. The company is owned by the shareholders but it
is managed may the board of directors.
Directors are salaried employees. They
may not be interested in maximising profit
because profit maximisation
not lead to maximisation of their incomes. Hence instead of maximising does
the managers may prot
try to fulfill other objectives.
92 Higher Secondary Economics owned by the entrepren
which production takes place may be preneur
the plot of land on also provide services. The
labour services
himself. Again, the entrepreneur may
in the production process. In tL
his
entrepreneur may also employ his own capital the entrepreneur
land owned by
includes the rent of the or
case, the gross profit entrepreneur or the interest of capital
the wage for the services rendered by the
we deduct the payments
owned by the entrepreneur. Thus, if from gross profit
to be made on account of factors of production supplied by the entrepreneur, wa
e

can get net profit.

When an entrepreneur hires a plot of land owned by another individual, the
rent is fixed by contract. Similarly, when the entrepreneur engages a worker in

lheu of wages, the wages are fixed by contract. If the entrepreneur borrows
funds, the rate of interest is also fixed by contract. But when the entrepreneur
employs his own land or his own labour services or his own capital in the
production process, no such agreement takes place. The question, therefore, is
or the wages
how can we determine the rent of land owned by the entrepreneur
for labour services supplied by the entrepreneur or the interest on the capital
funds provided by the entrepreneur ? In answer to this question it can be said
that if the entrepreneur leased his land to another person, he could have obtained
a rent. That rent will have to be taken as the rent on the plot of land owned by
the entrepreneur and used in the production process. Similarly, had the
entrepreneur worked elsewhere, he could have obtained certain wages which
should be taken as the value of labour services supplied by the entrepreneur in
the production process. In the same way, had the entrepreneur lent his capital
funds to other individuals, he could have obtained interest. That interest should
be taken to determine the rate of interest on the funds supplied by the
entrepreneur. This type of earnings of factors of production which are supplied
by the entrepreneur is known as implicit earnings or imputed costs. If this
implicit earning is deducted from gross profit, we can get net profit. If gross
profit is equal to implicit earning, net profit is zero. If gross profit is greater than
implicit earning, net profit is positive. On the other hand, if gross profit is less
than implicit earning, net profit is negative. Gross profit is thus always greater
than or equal to net profit.
7.1.2 Elements of Profit
According to Professor Taussig, profit is a mixed and vexed income. There are
several elements of profit.We know that the difference between the total revenue
and total contractual cost is the gross profit of the entrepreneur. From this gross
profit if we deduct the payments to factors ofproduction which are owned by the
entrepreneur himself, we can get net profit. The net profit has certain elements.
Let us now discuss the elements of net profit
First, net profit is the reward for risk-taking. The entrepreneur has to take
risk in organising the production process. Profit may be positive or negative. There
is no guarantee that the goods produced by him will be sold in the market. Hence
when a certain amount of money is spent to produce goods and services, there is a
risk involved. The reward for risk taking is profit. Professor Knight has
distinguished between risk and uncertainty. By risk he means a situation where
the occurrence of different events can be predicted with definite probabilities. But