Introduction
A profit-maximising firm makes its price and output decisions using the marginalist principle, which focuses on the relationship between marginal cost (MC) and marginal revenue (MR). The firm's primary objective is to maximise profit, which occurs when the difference between total revenue and total cost is at its greatest. This profit-maximising condition is achieved where the firm's marginal cost equals its marginal revenue, that is where MC = MR. This essay explains how a firm sets price and output to maximise profit, why deviations from this condition lead to sub-optimal outcomes, and why a firm with market power may go on to practise price discrimination.
The profit-maximisation condition: MC = MR
For a profit-maximising firm, the optimal level of output is found where marginal cost equals marginal revenue. Marginal cost is the additional cost incurred when producing one more unit of output, while marginal revenue is the additional revenue gained from selling that extra unit. When a firm produces where MC = MR, the cost of producing the last unit is exactly equal to the revenue it generates. This is the level of output, denoted Q₀, where profit is maximised, because any deviation from this point results in either forgone profit or losses.
Why not produce where MC is greater than MR?
If a firm produces at a level where MC exceeds MR, denoted Q₂, the cost of producing an additional unit is higher than the revenue earned from selling it. At this level the firm makes a loss on every additional unit produced. For example, if the marginal cost of producing one more unit is $10 but the marginal revenue from selling it is only $7, the firm loses $3 on that unit. This is clearly not profit-maximising, because the firm could improve profitability by reducing output. By cutting back production the firm avoids these losses and moves closer to the point where MC = MR. Producing where MC is greater than MR therefore leads to a sub-optimal outcome.
Why not produce where MC is less than MR?
Conversely, if a firm produces where marginal revenue exceeds marginal cost, denoted Q₁, it has an opportunity to increase profit by producing more. Here each additional unit contributes more to revenue than it costs to produce. For example, if the marginal cost of one more unit is $5 but the marginal revenue is $8, the firm gains an additional $3 of profit from that unit. The firm can keep raising profitability by expanding output until it reaches the point where MC = MR. At that point there are no further gains from increasing production, since the cost of an additional unit exactly equals the revenue it generates. Producing below this level means the firm is not maximising its potential profit.
The importance of MC = MR
The condition MC = MR is fundamental to the profit-maximisation objective because it identifies the output, Q₀, at which profit is highest. At this level the firm is neither producing too little nor too much; it is operating at its most profitable output. If it produced beyond this point, costs would begin to exceed revenues and profit would fall. If it produced less, it would forgo profit it could have earned on additional units. Only at the point where MC = MR does the firm achieve its profit-maximising level of output.
Why a firm may practise price discrimination
Third-degree price discrimination is practised primarily to maximise profit by charging different prices to different consumer groups based on their varying price sensitivities, that is their price elasticities of demand. By doing so a firm can capture a larger share of consumer surplus, the difference between what consumers are willing to pay and what they actually pay, and convert it into additional revenue.
Golden Village, a popular cinema chain in Singapore, provides a clear example. It charges different prices for the same film depending on the demographic segment: senior citizens and students are offered discounted tickets, while working adults pay the standard price. Working adults tend to have more inelastic demand, as they often have higher disposable incomes and are less sensitive to price changes, so Golden Village can charge them higher prices without significantly reducing demand.
Students and senior citizens typically have more elastic demand. They are more sensitive to price changes and would reduce their consumption of cinema tickets if prices were too high. By offering them a discount, Golden Village still attracts these groups, selling more tickets and filling more seats during showings that might otherwise run below capacity.
In essence, by segmenting its market and charging each group a price close to what they are willing to pay, Golden Village captures more consumer surplus and raises overall profit. The practice lets the cinema sell to a broader audience while extracting the maximum possible revenue from each consumer group.