Nature of Profit

Every business is organized with the objective of making profit. Profits are primary measure of
its success. The survival of any firm depends upon its ability to earn profit. Profit is described as
a reward for entrepreneur for successfully managing the business. Some economists claimed –
'profit as a residual income which is equal to the difference between the total revenue and the
total costs'.

Economic profits and Accounting profits

In accounting sense, profit is surplus of revenue over and above all paid out costs.
Accounting Profits = TR – (W+R+i+m)
m = costs of materials
While calculating accounting profit, only explicit costs or book costs are considered.

Economic Profits
For calculating economic profits, implicit costs/opportunity should be considered.
Economic Profits π = TR – (explicit costs + implicit costs)
implicit costs like rent on own property, interest on own capital etc.

Case 1
Tejaswami a fashion designer working as a manager of a Boutique for Rs. 120,000 per year
wants to start her own business by investing her own money of Rs.400,000 on which she could
earn 10 percent interest if deposited in a bank. Her estimated revenue during the first year of
operation is Rs. 300,000 and costs are: Salaries to employee Rs. 90,000, Supplies Rs. 30,000,
Rent Rs. 20,000 and utilities Rs. 2,000.
Calculate business profit.
Solution
Business profits = Total revenue – Total Costs
Revenue Rs. 300,000
Explicit Costs:
Salaries to employee Rs. 90,000
Supplies Rs. 30,000
Rent Rs. 20,000
 utilities Rs.2,000
Rs. 142,000 Rs. 142,000
Business Profits π Rs. 158,000
2) Calculation of Economic Profit
Economic Profits π = TR – (explicit costs + implicit costs)
Total Revenue Rs. 300,000
Less Explicit Costs Rs. 142,000
Less Implicit Costs Rs. 160,000
- Foregone salaries Rs. 120,000
- Interest @ 10% of Rs.400,000 Rs. 40,000
Economic Profits π/loss Rs. (2,000)

3) If she seeks your advice on whether to start the business or not, what will be your advice
and why?

4) What would be your advice if she could earn only 2 percent interest on her own money if
deposited in a bank?
Implicit Costs Rs. 128,000
- Foregone salaries Rs. 120,000
- Interest @ 2% of Rs.400,000 Rs. 8,000
Explicit Costs Rs. 142,000
Total cost Rs. 270,000
Revenue Rs. 300,000
Economic Profits π/loss Rs. 30,000

Case 2
Mr. Rayamaji, a MBM graduate from Shankar Dev Campus, turndowm a job offer of Rs.20,000
per month to start his own business. He will invest Rs.200,000 which earns 5 percent interest per
year in the bank deposit. The projected income of the first year is Rs.90,000 and the costs of
goods sold is Rs. 40,000. Other expenses are:

Advertising Rs.10,000
Depreciation Rs.10,000
Utilities Rs.3,000
Tax Rs.2,000
Other expenses Rs.5,000

Prepare a income statement using both accounting and economic perspective.

Objectives of a Firm
Profit maximizing model
Firm which aims at maximizing profits tries to determine its output in such a
manner as to obtain maximum possible net revenue. The net revenue of the firm is
calculated as:
i) Total Revenue (TR) & Total Cost (TC) approach; and
ii) Marginal Revenue (MR) = Marginal Cost (MC) approach

Profit (π) is the difference between Total Revenue (TR) and Total Cost (TC).
Hence, greater the difference between the total revenue and total cost higher is
the amount of profit.

TR – TC Approach under Perfect Competition

TC

- TR starts from the origin which means that when no output is produced,
revenue is zero.
- Total cost (TC) curve starts from a point R which lies above the origin.
- OF is the fixed cost which the firm has to incur even if it stops production for a
short time.
- B = zero profit where TR and TC are intersecting each other.
- OM = profit maximizing output.
- The vertical distance PN is the maximum between TR & TC curves. At output
M, the total profit curve is having a maximum at point S.

TR – TC Approach under Imperfect Competition

Under Imperfect competition a firm can sell larger output only at falling price.
Therefore, TR and TC curves continues to rise from left upwards to the right but the
rate of rise continues to fall as output sold increases.

Profit Maximizing Conditions

For profit maximization first derivation of profit function should be equal to zero.
= 0
Interms of MR and MC Approach
1) the first-order condition for profit maximization can be stated as: MR = MC.
2) MC must cut MR from below or Slope of MC > Slope of MR
First-order condition
= – =0
or =
or, MR = MC

The second order condition requires that

– <0
or < <0
Since d2 TR / dQ2 is the slope of MR and d2 TC / dQ2 is the slope of MC, the second-order
condition may also be written as
Slope of MR > Slope of MC
It implies that MC must have a steeper slope than MR or MC intersects the MR from below.

Case 3
A MBM graduate wanted to start a business. He estimated costs and revenue of the business.
Suppose his costs (C) and revenue (R) functions are given as:
C = 100 + 5Q2
R = 150 Q – 2.5 Q2
Find
a) Profit maximization output and price;
b) Maximum profit
Case 4
Find the equilibrium price, quantity, total revenue, total cost & total profit under following conditions
a) Profit maximization
b) Sales revenue maximization
c) Sales maximization with profit constraint
When, P = 20 – Q
C = TC = Q2 + 8Q + 2
Constraint π ≥ 8
Solution

Profit maximization
We have, Total Profit (π) = Total Revenue (TR) – Total Cost (TC)
a) Total Revenue (TR) =P×Q
= (20 – Q)Q
= 20Q – Q2
Total Profit (π) = (20Q – Q2) – (Q2 + 8Q + 2)
or, (π) = 20Q – Q2 – Q2 – 8Q – 2
or, (π) = – 2Q2 + 12Q – 2
To maximize the profit, we require = 0
=0
or, =0
or, – 4Q + 12 = 0
or – 4Q = – 12
∴ Q = = 3 units
The firm is maximizes its profit, producing at 3 units of output.
When Q = 3 units
P = 20 – Q
P = 20 – 3
P = Rs.17
Total Revenue (TR)
TR = 20Q – Q2
TR = 20 × 3 – 32
 TR = 60 – 9
TR = Rs.51
and Total Cost
TC = Q2 + 8Q + 2
TC = 32 + 8 × 3 + 2
TC = 9 + 24 + 2
TC = Rs.35
Total Profit
π = TR – TC
π = 51 – 35
π = Rs.16
∴ Q = 3 units of production, at which the profit is maximum. The Total Revenue (TR) is Rs.51.
b) Sales-revenue maximization
To maximize the revenue, we require = 0
Total revenue (TR) = P × Q
TR = (20 – Q) Q
TR = 20Q – Q2
=0
or, =0
or, 20 – 2Q = 0
or, – 2Q = – 20
or, Q = 10 units
In sales–revenue maximization, price is lower & output is greater than in profit maximization.
Therefore, the firm is producing 10 units of output to maximize its sales revenue.

Equilibrium Price
Price (P) = 20 – Q
P = 20 – 10
P = Rs.10
Total Revenue (TR)
TR = P × Q
TR = 10 × 10
 TR = 100
Total Cost (TC)
TC = Q2 + 8Q + 2
TC = 102 + 8 × 10 + 2
TC = 100 + 80 + 2
TC = Rs.182
Total Profit (π)
π = TR – TC
π = 100 – 182
π = 82 (Loss)
When Q = 10 units, the TR will be maximum i.e. Rs.100 & at this level P = Rs.10
In that condition, the firm incurring losses by Rs.82

c) Profit Constraint ≥ 8
We have, π = – 2Q2 + 12Q – 2
or, 8 = – 2Q2 + 12Q – 2
or, –2Q2 + 12Q – 10 = 0
or, 2Q2 – 12Q + 10 = 0
or, 2Q2 – 10Q – 2Q + 10 = 0
or, 2Q(Q – 5) – 2(Q – 5) = 0
∴ Q= either 5 or 1
Since our objective is to maximize sales with constraint π ≥ 8, the revenue i.e. sales is maximum at Q
= 5 unit.
where,
Total Revenue (TR) = 20Q – Q2
TR = 20 × 5 – 52
TR = 100 – 25
TR = Rs.75
Alternate way of solving problem c
2Q2 – 12Q + 10 = 0
ax2 + bx + c = 0
x=±
 Here,
a = 2, b = – 12, c = 10
Q=±
Q=±
Q=±
Q=±
∴ when,
+ ve, Q = = 5 – ve, Q = = 1
Since form's objective is to maximize sales with constraint π ≥ 8, the revenue i.e. sales is maximum at
Q = 5 unit. i.e, Revenue is Rs.75, where price is Rs.15 and cost is Rs.67.

Verification
When Q = 1 unit When Q = 5 unit
Price P = 20 – Q Price P = 20 – Q
P = 20 – 1 P = 20 – 5
P = Rs.19 P = Rs.15
Total Revenue (TR) Total Revenue (TR)
TR = P × Q TR = P × Q
TR = 19 × 1 TR = 15 × 5
TR = Rs.19 TR = Rs.75
Total Cost (TC) Total Cost (TC)
TC = Q2 + 8Q + 2 TC = Q2 + 8Q + 2
TC = 12 + 8 × 1 + 2 TC = 52 + 8 × 5 + 2
TC = Rs.11 TC = Rs.67
Total Profit (π) Total Profit (π)
π = TR – TC π = TR – TC
π = 19 – 11 π = 75 – 67
π = Rs.8 π = Rs.8