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Economic Cost, Maximisation (Profit, Revenue and Sales) and Satisficing

Economic Cost

The economic cost is considered to be the opportunity cost of production. It is the value that could have been generated had the resources been employed in their next best use. Examples of these opportunity costs are stated below.

Labour- a business owner may state a profit of £X but this may not include the value of their time. If he could have made £Y elsewhere but only made £X (Y>X) then he has actually made an economic loss as the opportunity cost of his labour wasn’t included.

Financial Capital – Start-up capital is considered an opportunity cost as it could have been put in an interest-bearing asset. If he invested £10,000 in the business but could have received £1000 in interest p/a then this must be included as an economic cost.

Depreciation – Physical capital will deteriorate over time and this needs to be included as an economic cost. It is valued as the difference between the purchase price and the second hand value of the good. 

Profit Maximisation

Profit = Revenue – Costs

We assume that the goal of firms is profit maximisation. To maximise profits the firm should produce at a level in which the Total Revenue curve is as far above the Total Cost curve as possible. 

To find this point we would subtract the highest point on the TR curve from the same point on the total cost curve. Note: At this point the gradient of the tangent to the TR curve is parallel to the gradient of the tangent to the STC curve.

If a firm faces the standard STC and TR curves as we can see above then the firm should choose the output level at which the total revenue curve is as far above the total cost curve in order to maximise profits. This occurs at Q* where the tangent to the STC curve has the same gradient as that of the TR curve. At Q- the firm would be maximising losses as this is the point where costs are as large as possible in relation to revenue. To calculate Q* set .

Another way to look at it is at the point where MC = MR providing that total revenue exceeds total cost. This is at point Q* with Q- being the quantity at which losses are maximised.

Profit maximisation: MR=MC where TR>TC.

If the firm produces below Q* then the MR from selling a marginal unit is greater than the marginal cost to produce it, therefore the firm would be able to increase profits by selling an additional unit. If the firm were to produce more than Q* it would discover that the MR from selling a marginal unit would be less than the MC to produce it, therefore the firm would make a loss by selling an additional unit of output above Q*.

Remember, profit maximisation can be achieved at the point where Marginal Revenue = Marginal Cost, this is the optimal quantity that should be produced.

In accounting Profit = Total Revenue – Total Costs, in economics we include the opportunity cost and hence include the economic costs (this is included in our model of costs as an imputed cost). Normal profit includes payment for enterprise and capital and is defined as:

The accounting costs can be perceived as an opportunity cost as if money wasn’t spent buying one good another good could have been purchased. In the Long Run a firm has to make enough revenue in order to cover the opportunity costs (and hence make a normal profit). If the firm isn’t making a normal profit (i.e. just covering accounting costs and not economic costs) then in the long run it would shut down. But in the short run the firm will remain open as long as variable costs are covered.

Supernormal/abnormal/economic profit is any profit after a normal profit is made and a subnormal profit is when the firm earns less than its normal profit.

Revenue Maximisation

William Baumol has argued that managers may set out with the intention of maximising revenues over profits. The point at which revenue is maximised is at the peak of the total revenue curve. Shareholders may not be that happy with this objective.

Larger flows of revenue may allow firms to increase their investment and cash flow hence revenue maximisation could be pursued as a policy in order to internally finance growth.
Revenue maximisation can be given by the formula Rmax => MR=0. As we can see from the graph a firm with the aim of maximising revenue would produce an output of Q1 at price P1. It is still possible to make a profit whilst undertaking revenue maximisation (in this example the profit of (P1-C1)*Q1 is made). However it is also possible for the firm to make a loss, something which it may choose to do in the short run for a more favourable cash-flow and for survival, but this wouldn’t occur if the firm couldn’t cover its average variable costs. It isn’t possible for a firm acting under perfect competition to revenue maximise.

Sales Maximisation

Similar to revenue maximisation, sales maximisation is the focus on increasing the volume of sales as oppose to the amount of profit or revenue. The point at which sales are maximised is where output is large as possible and the STC curve and the TR curve intersect. The firm would then only break even despite increasing sales.
Sales maximisation might be pursued in order for the firm to increase its market share. In the long run this may result in other firms in the industry withdrawing from the market, and this may allow the firm to focus on profit maximisation in the long run. There is also a principal-agent issue here; managers’ pay might be based on the number of sales and hence they would seek to maximise sales rather than profit, in order to increase their salary/bonuses. Also if the firm becomes bigger and more well known as a result of sales maximisation then the manager may become more well-known, his reputation may improve and he may be able to go on to better-paid jobs.

Sales maximisation can be given by the formula AR=ATC. If a firm is sales maximising then supernormal profit will equal 0; however the firm will still make a normal profit. From the graph we can see that a sales maximising firm would produce Q1 output at price P1 but wouldn’t make a supernormal profit. Sales maximisation can be undertaken by firms operating in a monopoly or perfectly competitive market (this is the same as if it were profit maximising). 

The object of maximisation (of profits, revenue or sales) may be replaced by the objective of satisficing. This is where managers have acceptable minimum levels of achievement which they must meet. Satisficing may occur with publicly listed companies as the manager (chief-executive) may make money if he meets his targets and may not receive any further profit from exceeding them. To discourage satisficing behaviour shareholders could pay chief executives in shares and it will then benefit them to ensure the firm is as profitable as possible.

Page last updated on 20/10/13