Topic: Profit Maximization of a Firm.

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Economics 101 Project

Topic: Profit Maximization of a firm.

Profit maximization has always been considered the primary goal of firms.The firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future).Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money. In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm. The expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period.

A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm produces beyond this point of equality between the marginal revenue and marginal cost, the marginal cost will be higher than the marginal revenue. In other words, the addition to total production beyond the point where marginal revenue equals marginal cost, leads to lower, not higher, profits. While every firm's primary motive is to maximize profits, its output decision (consistent with the profit maximizing objective), depends on the structure of the market it is operating under.

As mentioned earlier, firms' profit maximizing output decisions take into account the market structure under which they are operating. There are four kinds of market organizations: perfect competition, monopolistic competition, oligopoly, and monopoly.

Perfect Competition

Perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. For a market structure to be deemed “Perfectly Competitive”, it needs to have the following characteristics: 1) Many Buyers and sellers, but none of which are large enough to influence the price of a product in the market. 2) Each firm produces a homogeneous product; that is the products are indistinguishable from the other firm’s product in the same market. 3) Firms have little or no restrictions towards entering or exiting the market, thus increasing competition 4) Buyers and sellers have all the necessary information to run a business effectively, such as product prices, quality, source of supply etc.

A firm that is perfectly competitive is also known as a price taker, which means that the seller does not the ability to control the price of a product it sells but are rather determined by the market.

Perfect Competition in the Short-Run
In perfect competition, a firm’s demand curve perfectly elastic or horizontal.

In the short run, it possible for a firm to make a profit. This is because the Average Revenue which is denoted by P is higher than the point C which denotes the Average Cost.

Perfect Competition in the Long-Run

In the long run, Marginal Cost (MC) =Marginal Revenue (MR). So the firms cannot achieve profit. One of the reasons is because other investors see the opportunity to earn profit by investing, so the market share and profit of the older firms falls as the demand curve shifts downwards. When MR=MC, a firm does not have a profit nor incur a loss.

Monopolistic competition 
Monopolistic competition is imperfect competition where many competing producers sell products that are differentiated from one another. Examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. Monopolistically competitive markets have the following characteristics: * There are many producers and many consumers in the market, and no business has total control over the market price. * Consumers perceive that there are non-price differences among the...
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