This article describes the main objective of businesses – generating revenue and making profit. It describes different types of revenue such as the concepts o Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR).
It also explains the difference between Normal Profit and Abnormal Profit.
Finally, this post describes the idea of profit maximization by explaining the profit maximizing position where Marginal Cost (MC) equals to Marginal Revenue (MR).
Revenue
The overall objective of firms is to make profit. Without profit they would be unable to survive and would close down. Revenue is a measure of a company’s total sales in the market. As long as a company can control costs and efficiency, revenue will be higher than costs allowing them to make profit. Total, average and marginal cost can be used to assess the health and efficiency of a company; so too can total, average and marginal revenue.
1. Total Revenue (TR). Total Revenue (TR) is the actual amount of income received at a given level of output. It is calculated using the following formula:
Total Revenue (TR) = Quantity Sold (Q) * Price (P)
2. Average Revenue (AR). Average Revenue (AR) is revenue per unit sold (often the same as the selling price). It is calculated using the following formula:
Average Revenue (AR) = Total Revenue (TR) / Quantity Sold (Q)
3. Marginal Revenue (MR). Marginal Revenue (MR) is what is earned by selling an extra one unit of output. It is calculated using the following formula:
Marginal Revenue (MR) = Change in Total Revenue (∆TR) / Change in Quantity Sold (∆Q)
Profit
In Economics, there are two types of profit such as Normal Profits and Abnormal Profits (sometimes also called Supernormal Profits).
A. Normal Profit. Normal Profit is measured by the benefits that could be gained, if resources were used for another use. In other words, it is the opportunity cost of production. For example, A person who could earn USD$10,000 per month working for a company, may choose to start their own firm. In this case, they are able to earn USD$10,000 per month, if their resources are used to work for another firm. Therefore, we could assume they will expect to make at least USD$10,000 per month from their own firm. This is the minimum profit level they will accept to remain supplying the market.
In this particular example, this accepted level is the owners’ own salary; however all firms will have a required level of profit if they are to continue operating in a market. If it is possible to earn greater benefits (profit) by allocating resources elsewhere, the firm will leave the market.
Normal profit is included as a cost – if profit levels fall below this, perhaps because of changes in fashion or because the company has been priced out of the market, then they will leave the market. This minimum is called Normal Profit. Without it, resources are allocated elsewhere. In the case above, if the firm is unable to make normal profit, the person will close the company and choose to be employed by another firm.
B. Abnormal profit. Abnormal Profit is when profits are higher than normal profit levels. For example, the sole trader above is earning USD$15,000 instead of USD$10,000. Abnormal profit is likely in markets which are new as there is a shortage or there are barriers to entry. Abnormal profits attract new firms to the market. This in turn causes price to drop as they increase supply in the market.
Profit maximization
Profit maximization means achieving the most profit possible for a firm. Marginal Cost (MC) can be used together with Marginal Revenue (MR) to show the level of output that leads to profit maximization.
Marginal Cost (MC) is the change in Total Cost (TC) by producing one extra unit of output while Marginal Revenue (MR) is the increase in Total Revenue (TR) from selling one extra unit of output.
Profit maximization can be calculated where Marginal Cost (MC) equals to Marginal Revenue (MR). On the table below, profit maximization occurs when the level of output is 7 units produced.
| Output (in units) | Marginal Revenue (MR) in USD$ | Marginal Cost (MC) in USD$ | Addition to Total Profit in USD$ |
|---|---|---|---|
| 1 | $25 | $35 | – $10 |
| 2 | $25 | $26 | – $1 |
| 3 | $25 | $14 | $11 |
| 4 | $25 | $15 | $10 |
| 5 | $25 | $16 | -$9 |
| 6 | $25 | $18 | $8 |
| 7 | $25 | $25 | $0 |
| 8 | $25 | $34 | – $9 |
| 9 | $25 | $47 | – $22 |
Even though the addition to total profit is zero, it is important to remember that Normal Profit is included as a cost.
In summary, he main objective of businesses is to generate revenue and minimize costs aiming for profit maximization. Profit maximization is when Marginal Cost (MC) equals to Marginal Revenue (MR). Normal profit is included as a cost, so even though the last unit may add nothing to profit the firm still produces this unit.
