Profit Maximization Meaning
Many businesses want to be as profitable as possible. Therefore, they pursue profit maximization. To understand the meaning of profit maximization, you first need to know the definition of profit. Profit is the difference between a company's income and the costs it incurs. A company with high revenue but also high costs may end up with little profit in the end, while a company with lower revenue but much lower costs might ultimately make more profit.
Profit maximization is a term in economics and involves the pursuit of maximum profit. It looks at the combination of price and production volume at which profit is maximized. This involves determining the optimal price to sell the product and the quantity at which it is sold.
Useful Links:
The market structure in which a company operates plays a role in profit maximization. Maximizing profit in a monopoly is calculated differently than in perfect competition. In practice, perfect competition is rare, but we'll provide you with an example so you understand how profit maximization is calculated in this case. We'll also give you an example of calculating profit maximization in the case of imperfect competition.
Perfect competition refers to a market with many suppliers and many buyers. All suppliers offer the same product, and this product is homogeneous. This means that consumers do not differentiate between products from different suppliers. As a result, both buyers and suppliers have no influence on the price of a product.
In perfect competition, you calculate maximum profit by calculating Marginal Revenue (MR) - Marginal Cost (MC). Marginal revenue is the revenue from one product, which is also the selling price. Marginal cost is the cost of producing one unit of the product. As long as the marginal cost of a product is lower than the revenue from selling that same product, your profit increases. Maximum profit is achieved when MR = MC, which means that marginal revenue is equal to marginal cost.
Because in perfect competition, the supplier has no influence on the price, this means that the supplier will always offer the product at the equilibrium price. This applies to all products, and the quantity doesn't matter. This means that the price (P) is always equal to the average revenue (AR). The MR for each product is also the same. Therefore, when calculating profit maximization in perfect competition, P=AR=MR.
To calculate maximum profit, you use two graphs. In the first graph, you plot the collective supply against the collective demand. At the intersection of these two lines, you find the equilibrium price.
In the other graph, you draw the MR line at the height of the equilibrium price because in perfect competition, the supplier always offers the product at this price. In this graph, you also draw a line for the MC. We now know that you achieve maximum profit when MR equals MC. Therefore, find the intersection point of these two lines. In the same graph, you also draw a line for the average total cost (ATC). Check the value of ATC at the intersection of the MR and MC lines. Now you know the level of average total costs when producing the optimal quantity. Therefore, you can now fill in the formula and calculate maximum profit.
The formula is:
Maximum profit = (p* - ATC) x q*
In this equation, p* is the equilibrium price, ATC is the average total cost, and q* is the equilibrium quantity.
Let's assume the equilibrium price of a product is €10, the average total cost is €5, and the equilibrium quantity is 100 units. Then you get:
Maximum profit = (€10 - €5) x 100
Maximum profit = €500
In imperfect competition, the supplier does have an influence on the price of the product. However, the supplier must also consider reduced sales at a higher price. Consumers now have alternatives, and in that case, they may choose another product at a lower price.
Depending on the form of imperfect competition, consumers have more or fewer options to switch to another product. In monopolistic competition, there are many other suppliers with heterogeneous products. This gives consumers many choices, and there will be a significant impact of a price increase. In an oligopoly or a monopoly, there are fewer choices, and the effect of a price increase is less significant.
Even when calculating maximum profit for an oligopoly, you look for the point at which marginal revenue equals marginal cost. However, in this calculation, you also need to consider other competitors. You can do this by putting different values in a table. In the table, you list the various prices, the quantity demanded at each price, and the quantity of products supplied by competitors. By subtracting the number of products from competitors from the total demand, you can calculate how many products the company can sell at a certain price.
In the table, you also include total revenue (the number of products you sell multiplied by the price) and total costs (the number of products you sell multiplied by the marginal costs). You also include the marginal costs and marginal revenue. By finding the point at which marginal costs and marginal revenue are equal, you determine the maximum number of products the company should sell and at what price. This way, you also know what the maximum profit will be.
It seems logical that many companies take profit maximization as a starting point. After all, many businesses aim to maximize their profits. However, profit maximization is not always the right starting point. More and more companies are shifting their focus from profit maximization to purpose maximization.
Purpose is more important than ever. In purpose maximization, a company looks at a greater purpose or utility. Think of combating climate change or ensuring good working conditions for all employees. This is a trend that has become increasingly visible in recent years. Aaron Hurst described this trend in his bestseller ‘The Purpose Economy’ as the fourth economic revolution. The economy is moving further towards an economy of meaning. In this type of economy, sharing is more important than owning, and personal growth takes precedence over economic growth. A company should not strive solely for maximum profit but rather for the maximum value they can provide to society and the world.
This does not mean that making a profit is no longer important. A company can't contribute much to the world if it operates at a loss. However, there needs to be a better balance between the economic profit a company makes and the value it adds to the world. Achieving a high profit in the purpose economy is not a shame, but the way that money is earned should be fair and justifiable.
This trend is not entirely new. Some large companies dedicated to making the world a better place have existed since the 1970s. More companies are now joining this trend. A purpose-driven organization doesn't necessarily have to aim for world-changing transformations. Any goal that goes beyond economic gain counts. There are also companies that prioritize customer satisfaction far above economic interests. As long as customers are satisfied, profit matters less. This is another example of a purpose-driven enterprise.
Furthermore, various studies have shown that companies focused on purpose maximization achieve better results than other businesses. The exact numbers may vary from study to study, but it's clear that companies with a clear social purpose perform better in the stock market, with customers, and in terms of employee satisfaction.
The shift towards purpose maximization at the expense of profit maximization seems irreversible. The new generation of consumers values the societal purpose a company has and is willing to pay for it. However, it's crucial that a business genuinely integrates this purpose into its core values and clearly communicates it. It must not be mere window dressing, as consumers can easily see through that.
Profit maximization is not always the right starting point nowadays and seems to be fading into the background. Making money and achieving high profits are enjoyable, but they should no longer be the primary driving force of a company. If a business wants to stay in tune with the times, it's high time to reflect on its core values.
If your company also wants to focus more on purpose maximization instead of profit maximization, you should incorporate this into your sales efforts. Consumers need to know what you're selling and why you're selling it. They should understand the motives behind your product, making them more likely to make a purchase. Need some help with this? Consider seeking assistance from a sales expert. This way, you'll stay up-to-date and boost both your company's purpose and revenue.
Profit maximization is the pursuit of the highest possible profit for a business. It involves finding the ideal combination of price and production volume to maximize profit. It's about optimizing revenue and costs to make the difference between them as significant as possible.
In perfect competition, you calculate maximum profit by subtracting marginal revenue (MR) from marginal cost (MC). MR represents the revenue from selling one additional unit, while MC is the cost of producing one additional unit. Maximum profit is achieved when MR equals MC.
MR = MC means that the revenue from selling an extra unit equals the cost of producing that unit. This point marks the optimal production volume at which profit is maximized because producing more would not increase profit.
Marginal revenue (MR) is the revenue from selling one additional unit. It's equal to the price of the product because, in perfect competition, the price remains constant for all units sold. MR is used to determine the optimal production volume in the pursuit of profit maximization.