Profit Maximization: Definition, Equation & Theory

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Lesson Transcript
Instructor: Carol Woods

Carol has taught college Finance, Accounting, Management and Business courses and has a MBA in Finance.

What is profit maximization? Why would we want to maximize our profits, rather than revenues or sales? In this lesson we'll discuss what profit maximization is, how to calculate it, and why it's important to understand the concept.

What Is Profit Maximization?

Profit maximization refers to the sales level where profits are highest. You might assume that the higher the sales level, the higher the profits - but that is not always true!

The calculation for profit maximization is: the number of units where MR = MC.

How Do We Calculate Profit Maximization?

Okay, we definitely need a few definitions before we go any further!

• Profit: The money left over once you pay all your bills out of funds that come in from your customers. So for example, if you sell 5 necklaces for \$5 each, and the cost to purchase the necklaces is \$3, you will have revenues (customer monies in) of 5 necklaces x \$5 each = \$25, and costs of 5 necklaces x \$3 each = \$15. Your profit will be \$25 revenue - \$15 cost = \$10 remaining.
• MR: This stands for marginal revenue, which means the per-unit selling price of your item. It's often true that to sell more units you have to reduce the price, so marginal revenue appears as a line sloping down to the right on a graph.
• MC: This stands for marginal cost, which means the per-unit cost of your item. MC is generally shown as a line that slopes downward and then comes back up. This is based on the fact that per-unit costs will decrease to a certain point as you increase the number of units produced at your plant; then, once you reach capacity, your costs will increase as you either open a new plant or outsource production to other companies.

Here is an example of a graph showing the MR and MC lines. Units sold is tracked along the bottom axis, and the price/cost per unit is tracked on the vertical axis.

In this graph, the company will make a profit for each unit sold where MR is greater than MC, and lose money for each unit sold where MC is greater than MR. Profit is maximized at the point where the MR and MC lines cross.

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