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Simple Example of Profit Maximization

In: Business and Management

Submitted By nic6060
Words 362
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The goal of a competitive firm is to maximize profit, which equals total revenue minus total cost. We have just discussed the firm’s revenue, and in the last chapter, we discussed the firm’s costs. We are now ready to examine how the firm maximizes profit and how that decision leads to its supply curve.
A Simple Example of Profit Maximization
Let’s begin our analysis of the firm’s supply decision with the example in Table
2. In the first column of the table is the number of gallons of milk the Smith
Family Dairy Farm produces. The second column shows the farm’s total revenue, which is $6 times the number of gallons. The third column shows the farm’s total cost. Total cost includes fixed costs, which are $3 in this example, and variable costs, which depend on the quantity produced.
The fourth column shows the farm’s profit, which is computed by subtracting total cost from total revenue. If the farm produces nothing, it has a loss of $3 (its fixed cost). If it produces 1 gallon, it has a profit of $1. If it produces 2 gallons, it has a profit of $4 and so on. Because the Smith family’s goal is to maximize profit, it chooses to produce the quantity of milk that makes profit as large as possible. In this example, profit is maximized when the farm produces 4 or 5 gallons of milk, for a profit of $7.
There is another way to look at the Smith Farm’s decision: The Smiths can find the profit-maximizing quantity by comparing the marginal revenue and marginal cost from each unit produced. The fifth and sixth columns in Table 2 compute marginal revenue and marginal cost from the changes in total revenue and total cost, and the last column shows the change in profit for each additional gallon produced. The first gallon of milk the farm produces has a marginal revenue of $6 and a marginal cost of $2; hence, producing that gallon increases profit by $4

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