Let us make an in-depth study of the circumstances faced by all firms in profit maximisation.
Various Concepts of Profits:
In economics, profit refers to the difference between total revenue and total cost. Total cost includes the opportunity cost of capital. On the other hand, business people exclude the opportunity cost of capital in estimating total cost.
To them profits are only those revenue in excess of all costs, excluding the opportunity cost of capital. In other words, they include the cost of capital in business profits. This is why economists’ concept of profit is often referred to as pure or net profit, as opposed to accounting or business profit.
Economists often draw a distinction between net and normal profit. The latter refers to the minimum sum that must be paid to the entrepreneur to stay in business. In other words, it is the profit that a firm could make by using its resources, in their next best use, i.e., their opportunity cost. There is no doubt that the most important cost concept for business decision-making purposes is the concept of opportunity cost.
This implies that opportunity cost or normal profit should be included in cost of production of a business firm. Therefore, sub-normal and super-normal (excess) profit and profits that are less than or greater than the opportunity cost of employing resources elsewhere. Thus, in economics,
Total Profit = Total Revenue – Total Cost.
Total cost has three components:
a. Variable cost,
b. Fixed cost, and
c. Opportunity cost of capital.
The First rule: the Shut-down (Closedown) Rule:
It is to be noted at the outset that a firm’s initial objective is to cover its variable (avoidable) costs and to cover fixed costs and make excess profits thereafter. So the price of the product sold by the firm must be at least equal to variable cost per unit.
But if price is slightly less than AVC then firm would prefer to shut-down or close-down its operation completely. Thus, the minimum price acceptable to the firm is the one which is, at least, equal to AVC. In other words, P x Q = AVC x Q or TR = TVC.
Thus the first rule of profit- maximisation is that a firm will produce any positive quantity if, and only if, total revenue is equal to, or greater than, its total variable cost. In other words, if there is no level of output at which TR = TVC, i.e., if at all level of output TR = TVC output will be zero.
This is known as the shut-down rule, because it simply indicates when a firm, which is currently carrying on production, should be doing so. But it may alternatively be called the start-up rule because it shows when a firm, which has suspended its operation temporarily, will again start producing.
This rule simply signifies the fact that if, in the short run, it is not possible to maximise profit because of low demand for its product and low price, the best alternative is to minimise its losses. Loss can be minimised by reducing costs. Fixed costs are unavoidable. Hence, the only way to reduce cost is to avoid variable costs by closing down operations.
It may be noted, in this context, that certain costs can be avoided in the short run and others in the long run.
This is why the first rule of profit-maximisation has the following two applications:
Short-run Shut-down Conditions:
A firm’s decision regarding closing down its operation in the short run is governed by variable costs. It is because fixed expenses have to be met in any case. This is why some hotels in hill stations keep a few rooms open in the off-season. They also offer special discount to their customers. The basic objective is to cover variable costs and, if possible, a portion of fixed costs. Thus, fixed costs are irrelevant for business decisions.
The following example will clarify the point:
The manager of a restaurant which is open from 6.00 a.m. to 10.00 p.m. is thinking of keeping the restaurant open 24 hours a day. Under the current 16 hour-per-day operation, the restaurant yields on average Rs. 1,700 a day in revenues with total daily costs of Rs. 1,600. Of this, Rs. 240 per day is fixed cost — interest payments on capital borrowed from banks.
Suppose the manager estimates that keeping the restaurant open the additional eight hours would increase average daily total revenue to Rs. 2,150 and average daily cost to Rs. 2,000. Thus, the marginal revenue from remaining open all night is expected to be Rs. 450; the expected marginal cost is Rs. 400. Now the pertinent questions is should the restaurant be opened the additional eight hours? The answer is ‘yes’, because the marginal revenue exceeds the marginal cost; so, on average, profit would increase by Rs. 50 per day.
A closer scrutiny reveals that in making the decision, the manager considers only marginal cost. Fixed cost should not be taken into consideration for decision-making purposes. To see this, let us suppose that the manager had allocated a proportion of fixed cost to the additional eight hours. If this were done, 1/3rd of the fixed cost, Rs. 80, would be added to the cost of staying open for the remaining 8 hours of the day, the extra time.
Thus, the manager would compute the total cost of remaining open for 8 extra hours as Rs. 400 Rs. 80. Since this sum exceeds the additional revenues that would be generated, the decision would be to remain closed at night.
But, as we have seen, staying open adds Rs. 50 per day to profit. Taking fixed cost into consideration would have led to an incorrect decision. Since all business and economic decisions are taken at the margin, marginal changes are all that matter when making such decisions.
Long-run Shut-down Conditions:
Since all costs are variable in the long run a profit- maximising firm will stay in business in the long-run if it can cover all costs. Otherwise, it would close down its operations in the long run. In our above example, a hotel would stay in business hi the long run if it earns sufficient revenue to cover all costs of the whole year.
The Second Rule:
The second rule is that if a firm is to produce at all, it will produce its optimum (profit-maximising level of) output at the point where marginal cost is equal to marginal revenue.
The logic of this method is simple enough. So long as MR > MC, the firm will have to produce more since marginal profit is positive. At this stage, by producing one extra unit— the firm is adding more to its revenue than to its cost. If it stops at a point where MR > MC, some potential profit will be lost.
On the other hand, when MC >MR, marginal profit will be negative and contraction of output and sales will lead to more cost saving than revenue loss. So the firm would reduce its volume of production. Thus, it follows that a profit-maximising firm should produce neither more nor less when MR = MC.