Profit
Maximization


(Or,
Making
Money
with
Calculus!)



 The
goal
of
business
is
make
a
profit.

Consequently,
business
managers
are


tasked
with
the
generation
of
maximum
profits
for
their
organizations.

In
order
to


maximize
profits,
a
fundamental
question
must
be
answered:
How
many
units


should
the
firm
produce
for
sale?

Given
information
on
cost
and
demand,
this


decision
can
be
rendered
trivially
simple
with
the
help
of
some
basic
calculus.

This


paper
will
demonstrate
the
relatively
intuitive
calculus
of
profit
maximization.




An
Introduction
to
Profit



 A
discussion
of
profit
maximization
requires
a
basic
understanding
of
a
few


concepts.

Terms
like
profit,
revenue,
and
cost
may
be
familiar
to
business
and


economics‐minded
readers,
but
they’re
worth
rehashing
for
clarity’s
sake.

The


relationship
between
profit,
cost,
and
revenue
is
fairly
straightforward:
profit
is


equal
to
revenue
minus
cost.




Revenue
 refers
 to
 the
 income
 generated
 the
 sale
 of
 a
 product.
 
 Table
 1


illustrates
the
relationship
between
price,
quantity,
and
total
revenue.

Company
A


produces
100
units
of
a
good
and
sells
the
good
 
 Output
 Price
 Total


Quantity
 Revenue

at
 $4
 per
 unit,
 the
 total
 revenue
 generated
 A
 100
 $4
 $400

B
 200
 $8
 $1600

would
 be
 $4
 x
 100
 or
 $400.
 
 
 Company
 B
 C
 300
 $3
 $900

D
 400
 $2
 $800

E
 500
 $10
 $5000

produces
more
units
than
Company
A
(200)



















Table
1
­
Sample
Revenue

and
sells
them
at
a
higher
price
($8),
thus
generating
higher
revenue
of
$1600.


A

CalcCalculation

simple
 definition,
 then,
 is
 revenue
 equals
 price
 times
 quantity
 (of
 sales).
 
 
 Given
 a


price
function,
p,
we
can
generate
a
corresponding
revenue
function,
R.

If
Q
units
of

a
good
are
sold,
and
the
price
per
unit
is
represented
by
the
function
p(Q),
then
total


revenue
is

 


R(Q)
=
Qp(Q)



Cost,
on
the
other
hand,
is
simply


 Output
 Expense
 Total

the
firm’s
production
expense.

Table
2

Quantity
 per
Unit
 Cost

A
 100
 $2
 $200

shows
the
relationship
between
per
unit
 B
 200
 $7
 $1400

C
 300
 $2
 $600

expenditure,
quantity,
and
total
cost.

 D
 400
 $1
 $400

E
 500
 $9.50
 $4750

Company
A
produces
100
units
of
output
at
 







Table
2
­
Sample
Cost
Calculation


a
cost
of
$2
per
unit
for
a
total
cost
of
$200.

Company
B
produces
more
units
than


Company
A
(200)
at
a
higher
cost
($7
per
unit),
expending
a
total
of
$1400.

Total


cost,
then,
can
be
defined
as
expense
per
unit
times
quantity
produced.

For
the
sake


of
mathematics,
we
represent
the
relationship
between
output
of
a
commodity
and


the
costs
incurred
during
production
in
functional
form.

This
sort
of
function
is


called
a
cost
function
and
is
usually
given
the
abbreviated
name
C.

Total
cost,
then,



is
the
sum
of
fixed
costs
(FC)—unavoidable
costs,
even
if
you
product
zero
units
of


output—and
variable
costs
(VC)—those
which
increase
as
production
increases.

In


mathematical
terms,
TC
=
FC
+
VC.


Having
calculated
costs
and
revenue,


 Total
 Total
 Profit

Revenue
 Cost

it
is
easy
to
calculate
profits.

As
mentioned
 A
 $400
 $200
 $200

B
 $1600
 $1400
 $200

above,
profit
is
equal
to
revenue
minus

C
 $900
 $600
 $300

D
 $800
 $400
 $400

costs.
Profits
for
the
sample
firms
in
the

E
 $5000
 $4750
 $250


previous
examples
are
calculated
in
Table
 









Table
3
­
Sample
Profit
Calculation


3.

As
you
can
see,
Company
D
is
the
most
profitable
in
this
contrived
example,

where
revenue
($800)
minus
cost
($400)
equals
its
profit
of
$400.

Despite
its
large


revenues,
Company
E
only
managed
to
profit
$250.





If
we
call
P
the
profit
function,
then


P(Q)
=
R(Q)
–
C(Q)


where
Q
is
the
number
of
units
sold,
and
R
and
C
are
the
abovementioned
revenue


and
cost
functions.


The
Profit
Maximizing
Condition



 Given
the
profit
function
P

from
above,
it
is
relatively
simple
to
find
the
level


of
output/sales
Q
that
maximizes
P.

In
order
to
find
local
maxima,
we
simply
take


the
first
derivative
and
set
it
equal
to
zero1.

Walking
along
the
profit
curve,
this
will


be
the
point
where
the
curve
levels
off—the
top
of
the
hill,
so
to
speak.

So,
using
P


from
above,
we
see
that


P’(Q)
=
R’(Q)
–
C’(Q)
=
0


at
the
profit
maximizing
point.



If
this
is
true,
then
through
simple
algebraic
manipulation
we
can
also
see


that


R’(Q)
=
C’(Q)


at
the
profit
maximizing
level
of
output.

As
it
turns
out,
R’
and
C’
have
special


names.

R’,
or
marginal
revenue
(MR),
is
the
rate
of
change
of
revenue
with
respect



























































1
Of
course,
this
technique
only
shows
us
the
location
of
extreme
values.

That
is,
it
could
give
us
a

local
minimum
value
instead
of
the
desired
maximum
value.

In
order
to
confirm
that
we’ve
found
a

local
maximum,
we
can
use
the
second
derivative
test.

If
P’’(Q)
<
0,
we’re
at
a
local
maximum.

Also,

a
local
maximum
is
not
always
a
global
maximum.

Sometimes
it
will
make
more
economic
sense
to

produce
zero
units
of
output,
if
the
global
maximum
sits
below
zero.

to
the
number
of
units
sold.

C’,
or
marginal
cost
(MC),
is
the
rate
of
change
of
cost


with
respect
to
the
number
of
units
sold.


We
can
now
apply
this
rule
to
a
sample


problem.


Sample
Profit
Maximization
Case


A
firm
estimates
its
cost
to
produce
Q
units
of
output
as


C(Q)
=
90
+
1.25Q
­
0.004Q2
+
0.0008Q3


If
the
firm
sells
Q
units
of
output,
it
will
be
able
to
charge
the
following
price,
p,
where


p(Q)
=

10
­
0.004Q


At
what
level
of
output
will
the
firm
maximize
profits?

What
will
these
profits
be?


The
profit
maximizing
condition
is
MR=MC.

We’re
given
cost
and
price


functions,
so
we’ll
have
to
derive
marginal
cost
and
marginal
revenue
functions
from


these.

Marginal
cost
is
simply
the
derivative
of
the
cost
function.

Applying
simple


derivative
rules,
we
see
that


MC
=
C’(Q)
=
1.25
­
0.008Q
+
0.0024Q2


We
still
have
to
find
marginal
revenue.

First,
we’ll
have
to
find
the
total
revenue


function.


As
mentioned
above,
revenue
equals
price
times
quantity.

We’re
given


the
price
function,
so
multiplying
P
by
Q,
we
see
that


R(Q)
=
Qp(Q)
=
10Q
­
0.004Q2


From
here,
the
transition
from
revenue
to
marginal
revenue
is
just
a
matter
of


taking
the
derivative
of
R.


MR
=
R’(Q)
=
10
­
0.008Q




Applying
the
condition
and
setting
M
equal
to
MC:

 MR
=
MC





























10
­
0.008Q

=
1.25
­
0.008Q
+
.0024Q2

8.75
=
.0024Q2

3645.833
=
Q2

Q
=
 3645.833 

Q
=
60.38



Profit
will
be
maximized
at
60.38
units
of
output.

Since
.38
units
of
output
is

€
often
impossible—we
can’t
sell
.85
of
a
table—we’ll
round
down
to
60
units
of


output.

To
figure
out
our
profits,
we’ll
substitute
back
into
the
price
function
to
see


what
price
the
market
will
bear.


P(60)
=
10
–
0.004(60)



























































P(60)
=
10
­
.24



























































P(60)
=
9.76



Price
times
quantity
equals
revenue:



R(60)
=
60
*
p(60)

R(60)
=
60
*
9.76

Revenue
=

585.60




We
 need
 to
 calculate
 cost
 to
 find
 profit,
 so
 let’s
 substitute
 out
 profit


maximizing
Q
back
into
the
cost
function:


C(60)
=
90
+
1.25(60)
–
0.004(60)2
+
0.0008(60)3













































=
90
+
75
–
14.4
+
172.8













































=
323.40




Since
profit
=
revenue
minus
cost,
profits
in
this
case
are
equal
to


585.60
–
323.40
=
262.20




Looking
at
a
graph
of
the
cost
and
revenue
functions,
we
can
see
that
the


profit,
R(Q)
–
C(Q)
does
appear
greatest
at
approximately
60
units.

Furthermore,

the
slopes
of
the
lines
tangent
to
the
cost
and
revenue
curves—which
happen
to
be


MC
and
MR—appear
to
be
equal.












3500
 
It
should
be

$

3000
 noted
that
the


2500
 profit

R(Q)

2000
 maximization

C(Q)

1500
 point
doesn’t

1000

always
occur
at
a

500

positive
quantity.


Output
(Q)

0

Sometimes

0
 20
 40
 60
 80
 100
 120
 140
 160












































Figure
1
­
Revenue
and
Cost
Functions
 mathematics
and


reality
don’t
agree—you
can’t
produce
a
negative
quantity
of
output.

Likewise,
as


mentioned
above,
this
technique
could
give
you
a
local
minimum—so
it’s
always


worthwhile
to
confirm.

Here,
a
visual
scan
of
our
graph
clearly
indicates
a


maximum.

Basically,
it
is
always
worthwhile
to
make
sure
that
a
mathematical


answer
jives
with
reality.



 This
simple
technique,
setting
MR=MC,
can
be
used
for
a
variety
of
types
of


problems.

Given
demand
and
cost
functions,
we
can
generate
the
necessary
revenue


function
to
solve
as
in
the
example
above.

Given
relevant
information
about

consumer
patterns
and/or
production
processes2,
we
can
even
construct


cost/demand
functions
ourselves.

Profit
maximization
is
as
simple
as
finding
MR


and
MC,
then
applying
the
condition.

Actually
making
money,
on
the
other
hand,


might
not
be
so
easy.




Acknowledgements




 The
above
discussion
is
drawn
heavily
from
the
author’s
experience
through


coursework
in
business
and
economics
at
Dickinson
College.

That
said,
the
two


texts
cited
below
were
used
as
loose
references
throughout
the
composition
of
this


document.

Special
thanks
to
Steve
Erfle—your
instruction
and
multivariate


constrained
optimization
problems
made
simple
Pmax
problems
routine.









 


 


 


























































































2
For
example,
given
something
like
average
variable
cost
(total
variable
costs/Q),


we
can
work
our
way
towards
marginal
costs.

Multiplying
through
by
Q
gives
us
the

total
variable
costs.

From
there,
it’s
simply
a
matter
of
knowing
that
the
fixed
costs

don’t
matter
when
it
comes
to
finding
the
marginal
cost—fixed
costs
are
always

constant.



Works
Cited



Mansfield,
William,
and
W.
Bruce
Mansfield.
Management
Economics.
Boston:
W.
W.

Norton
&
Company,
Incorporated,
2002.
62‐65.



Stewart,
James.
Single
Variable
Essential
Calculus.
6th
ed.
2007.
103+.