Get the answer of: What are the Two Rules of Profit Maximisation?
A profit-maximising firm has to face two different but inter-related questions:
(a) Should it produce at all? (This is a question relating to shutting down or closing down any operation of the business.)
(b) If it is profitable to produce any positive quantity, what is the optimum output? (This is a question relating to determination of level of output which is consistent with profit maximisation.)
The first rule: the shut-down (close-down) rule:
It is to be noted at the outset that a firm’s initial objective is to cover its variable (avoidable) costs and then 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 levels of output TR = TVC output will be zero. This is known as the shut-down 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 for a firm to maximise profit because of low demand for its product and low price, the best alternative is to minimise its losses. In fact, in some situations loss minimisation appears to be the only alternative to profit maximisation. 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 its operation.
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 so 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.
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 operation in the long run.
The second rule: the marginalist 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.