Profits are maximised when marginal costs (MC) equal marginal revenue (MR). It is possible that over the forms potential range of outputs there are two points when MC=MR (point X and point Y).Producing at point X would not maximise profits because outputs up to X are produced where MC>MR. So technically profits are maximised when MC=MR AND the MC curve is rising (not falling), point Y on the diagram.
It is now clear why most companies pursue profit maximisation as their main business objective, as with out them a firm could not survive or grow. Profits can be affected by many factors, including price elasticity of demand, income elasticity of demand and labour productivity. Each of these influential factors will now be examined respectively.
“In a competitive market…the firm cannot set its own prices…prices are determined by the process of market interaction. The price resulting from this process is then given for each individual firm”. (Douma, S. and Schreuder, H., 1998, p23)
This ‘process of market interaction’ is supply and demand (the consumers demand vs. the producer’s ability to supply). This can be illustrated graphically:
According to Begg, D. and Ward (2004, p28) the graph shows three main things happening:
- If the price rises from P1 to P2 the quantity demanded will fall from Q1 to Q3.
- If the price falls from P1 to P3 the quantity demanded rises from Q1 to Q2
- P1 and Q1 occur when supply and demand are in equilibrium
The change in price/demand when demand/price is changed, respectively, is known as elasticity and is defined by Begg, D. and Ward (2004, p36) as “a measure of responsiveness of demand to a change in price… and can be calculated as:
Price elasticity of demand = % change in quantity demanded
% change in price”
When price elasticity is calculated in this way if the answer is greater than one then the product is relatively elastic. Parkin, Powell and Matthews (2005, p82) noted “If demand is elastic, a 1% price cut increases the quantity sold by more than 1% and the total revenue increases”. If the answer is less than one then the product is said to be inelastic. Parkin, Powell and Matthews (2005, p82) also noted “If demand is inelastic, a 1% price cut decreases the quantity sold by less than 1% and the total revenue decreases” If the answer is exactly equal to one the product is said to have unitary elasticity. How quantity demanded is effected by a price decrease when a good or service is elastic or inelastic was represented graphically by Begg, D. and Ward, D. (2004, p36):
Now we can see that products and services are either elastic or inelastic we can see how this affects revenue, and therefore profit. First we must see how sales revenue is defined. Atkinson, B. and Miller, R.(2002, p91) notes “The sales revenue of a firm is determined by multiplying the price of a product by the number of units sold” This is represented by the rectangle in the diagram (also, Atkinson, B. and Miller, R.2002, p91):
Atkinson, B. and Miller, R. (2002, p93) shows how revenue is effected when a price change of a good or service, that is elastic or inelastic, occurs.
Begg, D. and Ward, D.( 2004, p42) summarises the graphs well by stating “If demand is elastic then dropping prices raises total revenue. But if demand is inelastic, prices should be increased to in order to increase total revenue”
Now it can be seen what price elasticity of demand is we can now examine the factors which affect it. There are three main factors, as identified by Thomas, C.R. and Charles Maurice, S. (2005, p215). The first being ‘Availability of substitutes’
“The better the substitutes for a given product or service the more elastic the demand for that good or service. When the price of a good rises, consumers will substantially reduce consumption if they perceive that close substitutes are readily available (e.g. fruit of life insurance). Naturally, consumers will be less responsive to a price increase if they perceive that only poor substitutes a re available (e.g. petrol or tobacco)”
The second factor that affects price elasticity of demand is ‘Percentage of consumer’s budget’. Thomas, C.R. and Charles Maurice, S. (2005, p215) recorded:
“…we would expect the price elasticity to be directly related to the percentage of consumers’ budgets spent on the good. For example the demand for refrigerators is probably more price elastic than the demand for toasters because the expenditure required to purchase a refrigerator would make up a larger percentage of the budget of a “typical” consumer.”
So the larger percentage of a consumers budget the more price elastic the product is.
The final factor is time period of adjustment. When a price is first increased consumers will recognise the increase ant try to buy alternative products. Over time they may revert back to the old product, forgetting the price increase. If they cannot buy an alternative product they will keep purchasing the product but keep looking for a substitute (Thomas, C.R. and Charles Maurice, S., 2005, p215). Accordingly, the longer time frame to adapt the more price elastic in the long run, price inelastic in the short run.
So for a company to maximise profits, focusing on price elasticity of demand, it must first try to identify if its product is price elastic or price inelastic. Begg, D. and Ward, D. (2004, p97) notes
“…it might be difficult to calculate accurately the elasticity of demand for a product. A firm could attempt to determine the price elasticity of demand for a product by varying the price it charges and examining the extent to which demand changes”.
Once the firm has identified this it can vary its prices accordingly to maximise revenue and therefore profits (i.e. raise them if the product is price inelastic and lower them if product is price elastic)
The next factor which affects profit maximisation is income elasticity of demand, defined by Begg, D. and Ward, D. (2004, p25 and 40) as “… how demand reacts to a change in consumers’ income levels.” And is calculated by
“Income elasticity of demand = % change in quantity demanded
% change in income”
Parkin, Powell and Matthews, (2005, p86) states that “When income elasticity is calculated it can be positive or negative and falls into three different ranges:
- Greater than 1 (normal good, necessity. E.g. Wine and durable goods)
- Positive and less than 1 (normal good, luxury. E.g. Fruit juice and fresh meat)
- Negative (inferior good. E.g. Tobacco and Bread)”
Thomas, C.R. and Charles Maurice, S. (2005, p231) looked at an example of calculating the income elasticity of demand for normal and inferior products. In this example new cars (Metro Ford, a new car dealership in Atlanta) and used cars (Lemon Motors, a used car dealership in Atlanta) are used.
By looking at the research and the results you can see two main points emerging:
- Normal goods are demanded more when consumer income increases and less when income falls.
- Inferior goods are demanded more when income levels fall and demanded less when income levels rise.
(Begg, D. and Ward, D., 2004, p31)
So as income rises the demand curve for an inferior good would shift left, from D1 to D2. As income falls the demand curve for an inferior good would shift right, from D1 to D3.
Now income elasticity is understood we can look at its application. Atkinson, B. and Miller, R. (2002, p96) summarised these as:
“…income elasticity of demand is important as it can help us predict what will happen to demand as income levels change. Over time…the level of income has a tendency to rise. Using …income elasticity of demand for products, we can predict changes in spending patterns. We can expect to see a rise in spending on those products which have a high income elasticity of demand…where as those products with a low elasticity of demand…, demand will rise only slightly. Expenditure on these products with a negative income elasticity will fall… Firms may therefore want to consider selling products with high elasticity's of demand, as when income levels are rising, peoples expenditure on these goods will be rising more rapidly than on those goods with low income elasticity's of demand. On the other hand those firms which produce goods with low income elasticity's of demand will be less affected in times of recession as, despite the fall in income levels, demand for these products will remain fairly stable.”
From this we can see that firms have two options when centring on income elasticity of demand to maximise profits. The first is to produce products with high income elasticity of demand as over time the demand for these will increase, increasing revenue and profits. The second, and slower profit maximisation option, is to produce a product with a low income elasticity of demand, so slowly over time revenue will rise and remain stable during a recession.
The final section of this report will focus on labour productivity. Labour productivity is defined as “output per person employed or per person hour” by Griffiths, A. and Wall, S., (2004, p12). This can be calculated by
Unit Labour Cost = Cost of labour (wage)
Output per worker Quantity produced
Workforce
Increasing productivity (greater output per worker) is a way of reducing production costs. As costs would be reduced, this would then therefore increase profits. Thus a company needs to know how to increase productivity. Parkin, Powell and Matthews (2005, p515) identifies three factors that influence labour productivity:
- “Physical capital” (e.g. better tools or equipment)
- “Human capital” (e.g. knowledge and skill obtained through education and experience)
- “Technology” (e.g. technological advances- a task can be completed quicker by computer than by hand)
When one of these factors is increased the total value of goods or services produced increases. An increase in physical capital, human capital or technology makes the production function (the relation ship between the amount produced and the quantity of labour employed) shift upwards, from PF1 to PF2
By looking at labour productivity a company can see that if it wants to increase labour productivity, therefore reduce costs and increase profit, it needs to increase physical capital by providing the best tools for the workforce, increase human capital by providing training and increase technology by making sure all equipment used within the company is the most technological advanced that the company can afford.
In conclusion it can be seen that profit maximisation is a main business objective for most companies as it is crucial for survival and growth. Profit maximisation is affected by price elasticity of demand, in that the identification of whether a product is price inelastic or price elastic is very important, as prices changes have very different effects depending in which category a companies product or service falls into. For a company to maximise profit it needs to, identify if a product is price elastic or price inelastic. If the product is price inelastic the company can raise the price, as people will still buy it, to increase revenue and profits. If the product is price inelastic the company should reduce its price as, allot more people will buy it, to increase revenue and profits. Income elasticity of demand also effects profit maximisation. If a product has high income elasticity of demand, over time the demand for it will increase but if a product has a low income elasticity of demand, demand over time will remain stable, even during recessions. Labour productivity affects profit maximisation because if a companies labour force is not working to its full productivity rate this increases the company’s costs, therefore decreasing profit. For that reason to maximise profits a company needs to make their labour force as productive as possible by increasing physical capital through providing the best tools for the workforce, increasing human capital through providing training and increasing technology by making sure all equipment used within the company is technological advanced. This will reduce costs and therefore increase profits.
If a company examines these factors carefully it will maximise profits, achieve its main objective, and therefore insure its survival, growth and development within a competitive market for an extended stretch of time.
.
Bibliography
Atkinson, B. and Miller, R., 2002, Business economics, Pearson Education Limited, Essex
Begg, D. and Ward, D., 2004, Economics for business, McGraw-Hill Education, Berkshire
Douma, S. and Schreuder, H., 1998, Economic approaches to organisations, Second Edition, Prentice Hall Europe, Hertfordshire
Griffiths, A. and Wall, S., 2004, Applied economics, Tenth Edition, Pearson Education, London
Howard, M., 1983, Profits in economic theory, The Macmillan Press LTD, London and Basingstoke
Nellis, J. and Parker, D.,2002, Princlipes of business economics, Pearson Education Limited, Essex
Parkin, Powell and Matthews, 2005, Economics, Sixth Edition, Pearson Education Limited, Essex
Renshaw, G,. 2005, Maths for economics, Oxford University Press, Oxford
Thomas, C.R. and Charles Maurice, S., 2005, Managerial economics, Eighth edition, McGraw-Hill, New York