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Profit maximization

Learn how firms maximize profit by producing a quantity where marginal cost equals marginal revenue. In a competitive market, firms are price-takers, and marginal revenue is constant. Rational firms will produce more if marginal revenue is higher than marginal cost. Profit is maximized when the area of the rectangle formed by average total cost and marginal revenue is largest.

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Video transcript

- [Instructor] We've spent several videos talking about the costs of a firm. And in particular, we've thought about how marginal cost is driven by quantity and how average total cost is driven by quantity, and we think about other average costs as well. Now, in this video, we're going to extend that analysis by starting to think about profit. Now, profit, you are probably already familiar with the term. But one way to think about it, very generally, it's how much a firm brings in, you could consider that its revenue, minus its costs, minus its costs. And a rational firm will want to maximize its profit. And so to understand how a firm might go about maximizing its profit or what quantity it would need to produce to maximize its profit based on this, on its cost structure, we have to introduce revenue into this model here. And in particular, we are going to introduce the idea of marginal revenue. And we're going to assume that this firm is in a very competitive market, and so it is a price-taker. So regardless of how much this firm produces, the incremental revenue per unit of what it produces, maybe this is a doughnut company, the incremental amount per doughnut is going to stay the same regardless of how much this firm in particular produces. So let's say that the marginal revenue in this industry, in this market, is right over here. So one way to think about it is this would be the unit price in that market. So let me put that right over there, marginal revenue. Once again, for every incremental unit, how much revenue you're going to get, so it would just be the price of that unit. So how much would a rational firm produce in order to maximize its profit? If the marginal revenue is higher than the marginal cost, well, that means every incremental unit it produces, it's going to bring in some net money into the door. So it's rational for it to do it. So it would keep producing, keep producing, keep producing, keep producing. Now, it gets interesting as the marginal cost starts to approach the marginal revenue. As long as the marginal revenue is higher than the marginal cost, it's rational for the firm to produce. But right at that unit where the marginal cost is equal to the marginal revenue, well, there, on that incremental unit, the firm just breaks even at least on the margin. It might be able to utilize some of its fixed costs a little bit. But then, after that point, it makes no sense at all for it to keep producing. Why is that? Well, if the marginal cost is higher than the marginal revenue, that would be like saying, hey, I'm gonna sell a doughnut for $1 even though that incremental doughnut costs me $1.10 to produce. Well, no rational person, if they want to maximize their profit, would do that. So a rational firm that's trying to maximize its profit will produce the quantity where marginal cost intersects marginal revenue. It will produce this quantity right over there. Now, a natural question might be how much profit will it make from producing that quantity? Well, all you have to do is think about, this is the marginal revenue that it gets, and another way you could think about it, because this is constant, it's also going to be the average revenue that it gets per unit. And this right over here, is the average total cost per unit. And so what you could do is, this is how much it's getting on average per unit, and then multiply that times the number of units. And what you get is the area of this rectangle. So for those of you who are more visually inclined, one way to think about it is a profit-maximizing firm, a rational profit-maximizing firm, would want to maximize this area. Think about what would happen if they only produced this much. Well, then they're giving up a ton of area. Then the rectangle would only be this big. This would be the profit that the firm is going to be making from those units. And then if it decides, for some irrational reason, to produce more than this quantity that we settled on before, let's say this right over here, notice even though that the base of this rectangle is longer, the height is less, and this would actually have a lower area. And the reason why I feel very confident that this will have a lower area is because, in this situation, the firm is losing money on all of these incremental units where the marginal cost is higher than the marginal revenue. So big takeaway, a rational firm that's trying to maximize its profit will produce the quantity where marginal cost and marginal revenue are equal to each other.