What this lesson teaches
I can explain profit as total revenue minus total cost and find the profit-maximising output where MR equals MC with MC rising.
Syllabus 9570, 2.2.1(a). Objectives of Firms: Firms aim to maximise profits; Profit as the difference between total revenue and total cost; Profit-maximising output occurs at the point when marginal revenue (MR) equals marginal cost (MC) and where MC is rising
Make a guess
A firm aims to maximise profit but ends up producing more than the profit-maximising output. What is the most likely reason?
- The MR = MC rule does not apply to real firms.
- It does not know its exact MR and MC.
- It has stopped caring about profit.
Show the answer
It does not know its exact MR and MC.
Demand and costs must be estimated, and rivals react. A firm can aim for MR = MC and still miss it.
Firms rarely know their exact MR and MC, so they use estimates and rules of thumb.
The MR = MC rule assumes a firm knows its demand and costs precisely. In reality, it has to estimate them.
Demand depends on rivals, tastes and the economy, which are hard to predict. Costs can change suddenly, for example when energy prices spike.
So firms often use rules of thumb, such as adding a fixed mark-up to cost, and adjust as they learn.
In an exam, this is a useful evaluation point: a firm may aim to maximise profit but miss the exact output because its information is incomplete.
- Problem
- Firms estimate MR and MC.
- Response
- Rules of thumb, trials and adjustment.
Worked example: Should the repair shop open later?
A repair shop expects later opening to add $400 of weekly revenue and $300 of cost. If a rival also opens late, the extra revenue may be only $240.
- If the rival does not respond: profit rises by $100 a week.
- If the rival does respond: profit falls by $60 a week.
- The decision depends on information the shop does not have.
- A short trial would reveal the actual response before committing.
Watch out for this
A firm that does not produce exactly where MR = MC is not trying to maximise profit.
It may be trying, but lack the information to find the exact output.
Check your understanding
A firm cannot measure its MR and MC, so it prices at average cost plus 20%. What is the main risk of this rule of thumb?
- Its output may sit away from MR = MC, so it earns less than it could.
- It breaks competition law, because charging a set mark-up counts as collusion.
- It must make a loss, because a mark-up on average cost leaves fixed costs unpaid.
Show the answer
Its output may sit away from MR = MC, so it earns less than it could.
Right. A mark-up is a practical guess. It can leave the firm short of, or beyond, the output that maximises profit.