The Profit Maximising Rule

Janet runs a stall in the local market where she sells burgers. One assumption we can safely make for any business is that it aims to make a profit. It is the same for Janet. She is wanting her stall to do well so that it earns a tidy profit for her.

Janet knows that maximum profit is earned when the total revenue earned by the stall exceeds the total cost of running the stall by the largest possible amount. When Janet raises the price of her burgers, she starts getting less customers. When she reduces the price of her burgers, she gets a lot more customers which leads to Janet dropping the prices further. Customers further increase but at this stage, Janet realises her business is running in a loss.

Janet’s friend Barbara explains profit maximising rule to her. Barbara tells her that the marginal revenue in Janet’s Burger stall is the addition to total revenue that results from selling one additional burger, while marginal cost in her stall is the cost of making the additional burger. Her cost of burger is constant and hence her marginal revenue remains constant no matter how many burgers she sells. However, Janet’s profit would be maximised at a point where marginal cost equals marginal revenue. This is the golden rule of profit maximisation: Maximum profit occurs at a point where marginal cost is equal to marginal revenue. This is considered the optimal level of production.

Why does profit maximise when MC=MR? This is because if marginal revenue was higher than marginal cost (ie if Janet earned more per additional burger than she spent on making that additional  burger), Janet would happily decide to make more burgers as it increased her profit directly. Conversely, if marginal cost was higher than marginal revenue (ie if Janet spent more on making an extra burger than she earned by selling it), she would decrease production as expanding her output was having a negative impact on her profit. However, the optimum level of production for Janet would occur when marginal revenue equalled marginal cost, which would be the point of maximum profit.

Keeping the Profit Maximising rule in mind helps a business to set the right price for their products. Thus, if Janet chooses to maximise the profits of her burger stall, she must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR), and the Marginal Cost curve is rising. In other words, she must produce at a level where MC = MR.

 

At A, Marginal Cost < Marginal Revenue, then for each additional burger made, revenue will be higher than the cost so that Janet will make more burgers.

At B, Marginal Cost > Marginal Revenue, then for each extra burger produced, the cost will be higher than revenue so that Janet will make less burgers.

Thus, Janet’s optimal quantity of burgers produced should be at MC = MR

The MC = MR rule is quite adaptable so that Janet can apply the rule to many other decisions for her business. For example, she can apply it to hours of operation. She can decide to keep the burger stall open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.