Law Of Diminishing Marginal Utility

What Does Law Of Diminishing Marginal Utility Mean?

A law of economics stating that as a person increases consumption of a product - while keeping
consumption of other products constant - there is a decline in the marginal utility that person derives from
consuming each additional unit of that product.

Investopedia explains Law Of Diminishing Marginal Utility

This is the premise on which buffet-style restaurants operate. They entice you with "all you can eat," all
the while knowing each additional plate of food provides less utility than the one before. And despite their
enticement, most people will eat only until the utility they derive from additional food is slightly lower than
the original. 

For example, say you go to a buffet and the first plate of food you eat is very good. On a scale of ten you
would give it a ten. Now your hunger has been somewhat tamed, but you get another full plate of food.
Since you're not as hungry, your enjoyment rates at a seven at best. Most people would stop before their
utility drops even more, but say you go back to eat a third full plate of food and your utility drops even
more to a three. If you kept eating, you would eventually reach a point at which your eating makes you
sick, providing dissatisfaction, or 'dis-utility'.

law of diminishing marginal utility

  

Definition

Psychological generalization that the perceived value of, orsatisfaction gained from, a

good to a consumer declineswith each additional unit acquired or consumed. Even the
most delicious food, for example, will appeal less and less to its partaker as
its consumption reaches his or her satiationpoint and, if the consumption continues,
will result in sickness (disutility). Consumers deal with this phenomenon by consuming
a variety of goods rather than lots of one good.

Marginal utility
From Wikipedia, the free encyclopedia

In economics, the marginal utility of a good or service is the utility gained (or lost) from an increase (or
decrease) in the consumption of that good or service. Economists sometimes speak of a law of diminishing
marginal utility, meaning that there are diminishing returns in consumption, so that the first unit of
consumption of a good or service yields more utility than the second and subsequent units.
The concept of marginal utility played a crucial role in the marginal revolution of the late 19th century, and led
to the replacement of the labor theory of value by neoclassical value theory in which therelative prices of goods
and services are simultaneously determined by marginal rates of substitution in consumption and marginal
rates of transformation in production, which are equal in economic equilibrium.

Contents

 [hide]

1 Marginality

2 Utility

3 Diminishing marginal utility

o 3.1 Independence from presumptions of self-

interested behavior

4 Marginalist theory

o 4.1 Market price and diminishing marginal utility

 4.1.1 The paradox of water and diamonds

5 Quantified marginal utility

6 History

o 6.1 Proto-marginalist approaches

o 6.2 Marginalists before the Revolution

o 6.3 The Marginal Revolution

 6.3.1 The second generation

 6.3.2 The Marginal Revolution and Marxism

o 6.4 Reformulation

o 6.5 Revival

7 See also

8 References

[edit]Marginality

The term marginal refers to the effects of a small change in consumption, starting from some baseline level.
As Philip Wicksteed explained the term,

'Marginal considerations are considerations which concern a slight increase or diminution of the stock
of anything which we possess or are considering'[1]

Frequently the marginal change is assumed to start from the endowment, meaning the total resources
available for consumption (see Budget constraint). This endowment is determined by many things
 including physical laws (which constrain how forms of energy and matter may be transformed), accidents
of nature (which determine the presence of natural resources), and the outcomes of past decisions made
both by others and by the individual himself or herself.

For reasons of tractability, it is often assumed in neoclassical analysis that goods and services
are continuously divisible. Under this assumption, marginal concepts, including marginal utility may be
expressed in terms of differential calculus. Marginal utility can be defined as a measure of relative
satisfaction gained or lost from an increase or decrease in the consumption of that good or service.

However, strictly speaking, the smallest relevant division may be quite large. Frequently, economic
analysis concerns the marginal values associated with a change of one unit of a discrete good or service,
such as a motor vehicle or a haircut.

Utility
Main article:  Utility

Different concepts of utility underlie different theories in which marginal utility plays a role. It has been
common among economists to describe utility as if it were quantifiable, that is, as if different levels of
utility could be compared along a numerical scale.[2][3] This has significantly affected the development and
reception of theories of marginal utility. Concepts of utility that entail quantification allow familiar arithmetic
operations, and further assumptions of continuity and differentiability greatly increase tractability.

Contemporary mainstream economic theory frequently defers metaphysical questions, and merely notes
or assumes that preference structures conforming to certain rules can be usefully proxied by associating
goods, services, or uses thereof with quantities, and defines “utility” as such a quantification.[4]

Another conception is Benthamite philosophy, which equated usefulness with the production of pleasure
and avoidance of pain,[5] assumed subject to arithmetic operation.[6] British economists, under the
influence of this philosophy (especially by way of John Stuart Mill), viewed utility as “the feelings of
pleasure and pain”[7] and further as a “quantity of feeling” (emphasis added).[8]

Though generally pursued outside of the mainstream methods, there are conceptions of utility that do not
rely on quantification. For example, the Austrian school generally attributes value to the satisfaction of
needs,[9][10][11] and sometimes rejects even the possibility of quantification.[12] It has been argued that the
Austrian framework makes it possible to consider rational preferences that would otherwise be excluded.
[10]

In any standard framework, the same object may have different marginal utilities for different people,
reflecting different preferences or individual circumstances.[13]
[edit]Diminishing marginal utility
An individual will typically be able to partially order the potential uses of a good or service. For example, a
ration of water might be used to sustain oneself, a dog, or a rose bush. Say that a given person gives her
own sustenance highest priority, that of the dog next highest priority, and lowest priority to the rose bush.
In that case, if the individual has two rations of water, then the marginal utility of either of those rations is
that of sustaining the dog. The marginal utility of a third unit would be that of watering the roses.

(The diminishing of marginal utility should not necessarily be taken to be itself an arithmetic subtraction. It

may be no more than a purely ordinal change.[10][11])

The notion that marginal utilities are diminishing across the ranges relevant to decision-making is called
“the law of diminishing marginal utility” (and also known as a “Gossen's First Law”). However, it will not
always hold. The case of the person, dog, and roses is one in which potential uses operate independently
—there is no complementarity across the three uses. Sometimes an amount added brings things past a
desired tipping point, or an amount subtracted causes them to fall short. In such cases, the marginal utility
of a good or service might actually be increasing. For example:

 bed sheets, which up to some number may only provide warmth, but after that point may allow
one to effect an escape by being tied together into a rope;
 tickets, for travel or theatre, where a second ticket might allow one to take a date on an otherwise
uninteresting outing;
 dosages of antibiotics, where having too few pills would leave bacteria with greater resistance,
but a full supply could effect a cure.

The fact that a tipping point may be reached does not imply that marginal utility will continue to increase
indefinitely thereafter. For example, beyond some point, further doses of antibiotics would kill no
pathogens at all, and might even become harmful to the body. Simply put, as the rate of commodity
consumption increases, marginal utility decreases. If commodity consumption continues to rise, marginal
utility at some point falls to zero, reaching maximum total utility. Further increase in consumption of units
of commodities causes marginal utility to become negative; this signifiesdissatisfaction.

[edit]Independence from presumptions of self-interested behavior

While the above example of water rations conforms to ordinary notions of self-interested behavior, the
concept and logic of marginal utility are independent of the presumption that people pursue self-interest.
[14]
 For example, a different person might give highest priority to the rose bush, next highest to the dog,
and last to himself. In that case, if the individual has three rations of water, then the marginal utility of any
one of those rations is that of watering the person. With just two rations, the person is left unwatered and
the marginal utility of either ration is that of watering the dog. Likewise, a person could give highest
priority to the needs of one of her neighbors, next to another, and so forth, placing her own welfare last;
the concept of diminishing marginal utility would still apply.

[edit]Marginalist theory
Marginalism explains choice with the hypothesis that people decide whether to effect any given change
based on the marginal utility of that change, with rival alternatives being chosen based upon which has
the greatest marginal utility.

[edit]Market price and diminishing marginal utility

If an individual has a stock or flow of a good or service whose marginal utility is less than would be that of
some other good or service for which he or she could trade, then it is in his or her interest to effect that
trade. Of course, as one thing is traded-away and another is acquired, the respective marginal gains or
losses from further trades are now changed. On the assumption that the marginal utility of one is
diminishing, and the other is not increasing, all else being equal, an individual will demand an increasing
ratio of that which is acquired to that which is sacrificed. (One important way in which all else might not be
equal is when the use of the one good or service complements that of the other. In such cases, exchange
ratios might be constant.[10]) If any trader can better his or her own marginal position by offering a trade
more favorable to complementary traders, then he or she will do so.

In an economy with money, the marginal utility of a quantity is simply that of the best good or service that
it could purchase.

Hence, the “law” of diminishing marginal utility provides an explanation for diminishing marginal rates of
substitution and thus for the “laws” of supply and demand, as well as essential aspects of models
of “imperfect” competition.

The paradox of water and diamonds

Main article:  Paradox of value

The “law” of diminishing marginal utility is said to explain the “paradox of water and diamonds”, most
commonly associated with Adam Smith[15] (though recognized by earlier thinkers).[16] Human beings
cannot even survive without water, whereas diamonds are mere ornamentation or engraving bits. Yet
water had a very low price, and diamonds a very high price, by any normal measure. Marginalists
explained that it is the marginal usefulness of any given quantity that determines its price, rather than the
usefulness of a classor of a totality. For most people, water was sufficiently abundant that the loss or gain
of a gallon would withdraw or add only some very minor use if any; whereas diamonds were in much
more restricted supply, so that the lost or gained use would be much greater.
That is not to say that the price of any good or service is simply a function of the marginal utility that it has
for any one individual nor for some ostensibly typical individual. Rather, individuals are willing to trade
based upon the respective marginal utilities of the goods that they have or desire (with these marginal
utilities being distinct for each potential trader), and prices thus develop constrained by these marginal
utilities.

The “law” does not tell us such things as why diamonds are naturally less abundant on the earth than is
water, but helps us to understand how this affects the value imputed to a given diamond and the price of
diamonds in a market.

Quantified marginal utility

Under the special case in which usefulness can be quantified, the change in utility of moving from
state S1 to state S2 is

Moreover, if S1 and S2 are distinguishable by values of just one variable   which is itself quantified,
then it becomes possible to speak of the ratio of the marginal utility of the change in   to the size of
that change:

Diminishing marginal utility, given quantification

(where “c.p.” indicates that the only independent variable to change is  ).

 Mainstream neoclassical economics will typically assume that

is well defined, and use “marginal utility” to refer to a partial derivative

and diminishing marginal utility is similarly taken to correspond to

2.Indifference curve
From Wikipedia, the free encyclopedia

An example of an indifference map with three indifference curves represented

In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which

a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle
over another. One can equivalently refer to each point on the indifference curve as rendering the same level
of utility (satisfaction) for the consumer. Utility is then a device to represent preferences rather than something
from which preferences come.[1] The main use of indifference curves is in the representation of potentially
observable demand patterns for individual consumers over commodity bundles.[2]
 Contents

 [hide]

1 History

2 Map and properties of indifference

curves

3 Assumptions of consumer preference

theory

o 3.1 Application

o 3.2 Examples of indifference

curves

4 Preference relations and utility

o 4.1 Preference relations

o 4.2 Formal link to utility theory

o 4.3 Examples

 4.3.1 Linear utility

 4.3.2 Cobb-Douglas

utility

 4.3.3 CES utility

5 See also

6 Footnotes

7 Notes

8 References

9 External links

istory
The theory of indifference curves was developed by Francis Ysidro Edgeworth, Vilfredo Pareto and others
in the first part of the 20th century. The theory can be derived from ordinal utility theory, which posits that
individuals can always rank any consumption bundles by order of preference.
[edit]Map and properties of indifference curves

An example of how indifference curves are obtained as the level curves of a utility function

A graph of indifference curves for an individual consumer associated with different utility levels is called
an indifference map. Points yielding different utility levels are each associated with distinct indifference
curves and is like a contour line on a topographical map. Each point on the curve represents the same
elevation. If you move "off" an indifference curve traveling in a northeast direction (assuming positive
marginal utility for the goods) you are essentially climbing a mound of utility. The higher you go the
greater the level of utility. The non-satiation requirement means that you will never reach the "top", or a
"bliss point", a consumption bundle that is preferred to all others

Indifference curves are typically represented to be:

1. Defined only in the non-negative quadrant of commodity quantities (i.e. the possibility of having
negative quantities of any good is ignored).
2. Negatively sloped. That is, as quantity consumed of one good (X) increases, total satisfaction
would increase if not offset by a decrease in the quantity consumed of the other good (Y).
Equivalently, satiation, such that more of either good (or both) is equally preferred to no increase,
is excluded. (If utility U = f(x, y), U, in the third dimension, does not have a local maximum for
any x and y values.) The negative slope of the indifference curve reflects the law of diminishing
marginal utility. That is as more of a good is consumed total utility increases at a decreasing rate
- additions to utility per unit consumption are successively smaller. Thus as you move down the
indifference curve you are trading consumption of units of Y for additional units of X.
3. Complete, such that all points on an indifference curve are ranked equally preferred and ranked
either more or less preferred than every other point not on the curve. So, with (2), no two curves
can intersect (otherwise non-satiation would be violated).
4. Transitive with respect to points on distinct indifference curves. That is, if each point on I2 is
(strictly) preferred to each point on I1, and each point on I3 is preferred to each point on I2, each
point on I3 is preferred to each point on I1. A negative slope and transitivity exclude indifference
curves crossing, since straight lines from the origin on both sides of where they crossed would
give opposite and intransitive preference rankings.
5. (Strictly) convex. With (2), convex preferences imply that the indifference curves cannot the
concave to the origin, i.e. they will either be straight lines or bulge toward the origin of the
indifference curve. If the latter is the case, then as a consumer decreases consumption of one
good in successive units, successively larger doses of the other good are required to keep
satisfaction unchanged.
[edit]Assumptions of consumer preference theory

 Preferences are complete
 Assume that there are two consumption bundles A and B each containing two
commodities x and y. A consumer can unambiguously determine that one and only one of the
following is the case:
 A is preferred to B ⇒ A p B[3]
  B is preferred to A ⇒ B p A[3]
 A is indifferent to B ⇒ A I B[3]
 Note that this axiom precludes the possibility that the consumer cannot
decide,[4] and that a consumer is able to make this comparison with respect to every
conceivable bundle of goods.[3]
 Preferences are reflexive
 Means that if A and B are in all respect identical the consumer will recognize this fact and
be indifferent in comparing A and B
 A = B ⇒ A I B[3]
 Preference are transitive[nb 1]
 If A p B and B p C then A p C.[3]
 Also A I B and B I C then A I C.[3]
 This is a consistency assumption.
 Preferences are continuous
 If A is preferred to B and C is infinitesimally close to B then A is preferred to C.
 A p B & C → B ⇒ A p B.
 "Continuous" means infinitely divisible - just like there are an infinity of numbers
between 1 and 2 all bundles are infinitely divisible. This assumption makes indifference
curves continuous.
 Preferences exhibit strong monotonicity.
 if A has more of both x and y than B then A is preferred to B
 this is assumption is commonly called the "more is better" assumption
 an alternative version of this assumption is strong monotonicity which requires
that if A and B have the same quantity of one good, but A has more of the other then A is
preferred to B
 Indifference curves exhibit diminishing marginal rates of substitution
 This assumption assures that indifference curves are smooth and convex to the origin.
 This assumption also set the stage for using techniques of constrained optimization.
Because the shape of the curve assures that the first derivative is negative and the second is
positive.
 The marginal rate of substitution tells how much y a person is willing to sacrifice to get
one more unit of x.
 This is also called the substitution assumption. This is the most critical assumption of
consumer theory. Consumers are willing to give up or trade-off some of one good to get more of
 another. The fundamental assertion is that there is a maximum amount that "a consumer will give
up of one commodity to get one unit of other good is that amount which will leave the consumer
indifferent between the new and old situations"[6] The negative slope of the indifference curves
represents the willingness of the consumer to make a trade off. [6]
 There are also many sub-assumptions:
 Irreflexivity - for no x is xpx
 Negative transivity if xnot-py then for any third commodity z, either xnot-pz or znot-py or both.

pplication

To maximise utility, a household should consume at (Qx, Qy). Assuming it does, a full demand schedule can be deduced as
the price of one good fluctuates.

Consumer theory uses indifference curves and budget constraints to generate consumer demand curves.
For a single consumer, this is a relatively simple process. First, let one good be an example market e.g.
carrots, and let the other be a composite of all other goods. Budget constraints gives a straight line on the
indifference map showing all the possible distributions between the two goods; the point of maximum
utility is then the point at which an indifference curve is tangent to the budget line (illustrated). This follows
from common sense: if the market values a good more than the household, the household will sell it; if the
market values a good less than the household, the household will buy it. The process then continues until
the market's and household's marginal rates of substitution are equal.[7] Now, if the price of carrots were
to change, and the price of all other goods were to remain constant, the gradient of the budget line would
also change, leading to a different point of tangency and a different quantity demanded. These price /
quantity combinations can then be used to deduce a full demand curve.[8]
[edit]Examples of indifference curves

Figure 2: Three indifference curves where Goods Figure 3: Indifference curves for

X and Y are perfect substitutes. The gray line perfect complements X and Y. The
Figure 1: An example of an
perpendicular to all curves indicates the curves are elbows of the curves arecollinear.
indifference map with three
mutually parallel.
indifference curves represented

In Figure 1, the consumer would rather be on I3 than I2, and would rather be on I2 than I1, but does not
care where he/she is on a given indifference curve. The slope of an indifference curve (in absolute value),
known by economists as the marginal rate of substitution, shows the rate at which consumers are willing
to give up one good in exchange for more of the other good. For most goods the marginal rate of
substitution is not constant so their indifference curves are curved. The curves are convex to the origin,
describing the negative substitution effect. As price rises for a fixed money income, the consumer seeks
less the expensive substitute at a lower indifference curve. The substitution effect is reinforced through
the income effect of lower real income (Beattie-LaFrance). An example of a utility function that generates
indifference curves of this kind is the Cobb-Douglas function  . The negative
slope of the indifference curve incorporates the willingness of the consumer to means to make trade offs.
[9]

If two goods are perfect substitutes then the indifference curves will have a constant slope since the
consumer would be willing to switch between at a fixed ratio. The marginal rate of substitution between
perfect substitutes is likewise constant. An example of a utility function that is associated with indifference
curves like these would be  .

If two goods are perfect complements then the indifference curves will be L-shaped. Examples of perfect
complements include left shoes compared to right shoes: the consumer is no better off having several
right shoes if she has only one left shoe - additional right shoes have zero marginal utility without more
left shoes, so bundles of goods differing only in the number of right shoes they includes - however many -
are equally preferred. The marginal rate of substitution is either zero or infinite. An example of the type of
utility function that has an indifference map like that above is  .

The different shapes of the curves imply different responses to a change in price as shown from demand
analysis in consumer theory. The results will only be stated here. A price-budget-line change that kept a
consumer in equilibrium on the same indifference curve:
 in Fig. 1 would reduce quantity demanded of a good smoothly as price rose relatively for that
good.
in Fig. 2 would have either no effect on quantity demanded of either good (at one end of the
budget constraint) or would change quantity demanded from one end of the budget constraint to
the other.
in Fig. 3 would have no effect on equilibrium quantities demanded, since the budget line would
rotate around the corner of the indifference curve.[nb 2]

Preference relations and utility

Choice theory formally represents consumers by a preference relation, and use this representation to
derive indifference curves showing combinations of equal preference to the consumer.

[edit]Preference relations
Let

 = a set of mutually exclusive alternatives among which a consumer can choose

 and   = generic elements of  .

In the language of the example above, the set   is made of combinations of apples and
bananas. The symbol   is one such combination, such as 1 apple and 4 bananas and   is
another combination such as 2 apples and 2 bananas.

A preference relation, denoted  , is a binary relation define on the set  .

The statement

is described as '  is weakly preferred to  .' That is,   is at least as good as   (in
preference satisfaction).

The statement

is described as '  is weakly preferred to  , and   is weakly preferred to  .' That is,
one is indifferent to the choice of   or  , meaning not that they are unwanted but
that they are equally good in satisfying preferences.

The statement
 is described as '  is weakly preferred to  , but   is not weakly preferred to  .'
One says that '  is strictly preferred to  .'

The preference relation   is complete if all pairs   can be ranked. The

relation is a transitive relation if whenever   and   then  .

Consider a particular element of the set  , such as  . Suppose one builds
the list of all other elements of   which are indifferent, in the eyes of the
consumer, to  . Denote the first element in this list by  , the second by   
and so on... The set   forms an indifference curve
since   for all  .

Formal link to utility theory

In the example above, an element   of the set   is made of two numbers: The number of apples, call
it   and the number of bananas, call it 

In utility theory, the utility function of an agent is a function that ranks all pairs of consumption bundles by

order of preference (completeness) such that any set of three or more bundles forms atransitive relation.
This means that for each bundle   there is a unique relation,  , representing
the utility (satisfaction) relation associated with  . The relation   is called
the utility function. The range of the function is a set of real numbers. The actual values of the function
have no importance. Only the ranking of those values has content for the theory. More precisely,
if  , then the bundle   is described as at least as good as the
bundle  . If  , the bundle  is described as strictly preferred to the
bundle  .

Consider a particular bundle   and take the total derivative of   about this point:

 or, without loss of generality,

 (Eq. 1)

where   is the partial derivative of   with respect to its first argument,
evaluated at  . (Likewise for  )

The indifference curve through   must deliver at each bundle on the curve the same
utility level as bundle  . That is, when preferences are represented by a utility
function, the indifference curves are the level curves of the utility function. Therefore, if one is
to change the quantity of   by  , without moving off the indifference curve, one must also
change the quantity of   by an amount   such that, in the end, there is no change in U:
 , or, substituting 0 into (Eq. 1) above to solve for dy/dx:

Thus, the ratio of marginal utilities gives the absolute value of the slope of the
indifference curve at point  . This ratio is called the marginal rate of
substitution between   and  .

[edit]Examples
[edit]Linear utility

If the utility function is of the form   then the marginal

utility of   is   and the marginal utility of   is  .
The slope of the indifference curve is, therefore,

Observe that the slope does not depend on   or  : the indifference curves
are straight lines.
[edit]Cobb-Douglas utility

If the utility function is of the form   the marginal utility

of   is   and the marginal utility of   

is  .Whereα < 1. The slope of the
indifference curve, and therefore the negative of the marginal rate of
substitution, is then

[edit]CES utility

A general CES (Constant Elasticity of Substitution) form is

where   and  . (The Cobb-Douglas is a special

case of the CES utility, with  .) The marginal utilities are
given by
 and

Therefore, along an indifference curve,

These examples might be useful

for modelling individual or aggregate demand.

3. methodology of economics maximization

objectives of business - alternatives to profit maximisation

Introduction

In much of economic theory, it is assumed that a business aims to maximise profits.

In reality, most businesses which are run for “commercial gain” do have profit maximisation as an
important objective – since the shareholders have taken a risk investing in the business and require a
return (profit) to compensate them for their risk.

There are, however, many other potential financial objectives of a business. The table below
summarises three alternative models of business objectives that have attracted popular support:

Sales Maximisation Model (Baumol)

This model argues that businesses try to maximise sales or revenues rather than profits. There are
several possible motives for such an objective:

• Grow or sustain market share

• Ensure survival
• Discourage competitors (particularly new entrants to a market)
• Build the prestige of the senior management – who like to be seen running a large rather than a
particularly profitable business
• Achieve bonuses – if these are based on revenues rather than profits

Management Discretion Model (Williamson)

In this model, Williamson argues that management act to further their own interests – in other words to
achieve personal utility rather than to meet the interests of outside investors. Businesses run with this
kind of objectives tend to deliver high levels of remuneration to management rather than the highest
possible profits.

Consensus Model (Cyert & March)

The consensus model presents a slightly more complicated model of business objectives. In this case, it
is argued that a business is an organisational coalition of shareholders, managers, employees and
customers – each with different objectives. Management therefore try to reach a consensus with these
different groups – each of which must settle for less than they would otherwise want. Shareholders,
therefore have to settle for profits that are less than the theoretical maximum, perhaps to ensure that
employees do better.

Wealth Maximisation Model

The theory of corporate finance suggests an alternative financial objective to profit maximisation that
can provide a day-to-day focus for management. This theory assumes that management’s main job is to
maximise the value or wealth of the business. Within this context, management seek to ensure that
investments made by the business earn a return that is satisfactory to shareholders.

PROFIT MAXIMIZATION:

The process of obtaining the highest possible level of profit through the production and sale
of goods and services. The profit-maximization assumption is the guiding principle
underlying production by a firm. In particular, it is assumed that firms undertake actions
and make the decisions that increase profit. The profit-maximization assumption is the
production counterpart to the utility-maximization assumption for consumer behavior.

Profit is the difference between the total revenue received from selling output and the total
cost of producing that output. The profit-maximization assumption means that firms seek
a production level that generates the greatest difference between total revenue and total
cost. If a firm maximizes profit, then it is generating the highest possible reward
for entrepreneurship resources.

The Profit Maximizing Choice

Consider how profit maximization might work for The Wacky Willy Company. Suppose that
The Wacky Willy Company generates $100,000 of profit by producing 100,000 Stuffed
Amigos. This profit is the difference between $1,000,000 of revenue and $900,000 of cost.

 If profit falls from this $100,000 level when The Wacky Willy Company produces
more (100,001) or fewer (99,999) Stuffed Amigos, then it is maximizing profit at
100,000.

Alternatively, if profit can be increased by producing more or less, then The Wacky Willy
Company is NOT maximizing profit.

 Suppose, for example, that producing 100,001 Stuffed Amigos adds an extra $11 to
revenue but only $9 to cost. In this case, profit can be increased by $2, reaching
$100,002, by producing one more Stuffed Amigos. As such 100,000 is NOT the profit
maximizing level of production.
  In contrast, suppose that producing 99,999 Stuffed Amigos reduces cost by $11 but
only reduces revenue by only $9. In this case, profit can also be increased by $2,
reaching $100,002, by producing one fewer Stuffed Amigos. As such, 100,000 is NOT
the profit maximizing level of production.

While this assumption has numerous questions concerning its validity in the real world (do
firms ACTUALLY try to maximize profit?), it does provide an excellent method of economic
analysis.

Marginal Equality
The economic analysis of short-run production reveals that firms maximize profit by
producing a quantity that equates marginal revenue with marginal cost. This equality holds
regardless of the market structure (perfect competition, monopoly, monopolistic
competition, or oligopoly) under study. While the implications of profit maximization for
different market structures also differ, the process of maximizing profit is the essentially the
same.

Other Objectives
On a day-to-day basis most firms likely pursue goals other than profit maximization. Three
most noted objectives are sales maximization, personal welfare, and social welfare.

 Sales Maximization: Many firms make decisions designed to increase or maximize

production and the amount of output sold. More sales means more revenue, but not
necessarily more profit.

 Personal Welfare: Firms are occasionally motivate to increase the personal welfare of
owners or employees, especially the employees who control the operation of the
firm. Profit is usually sacrificed in the process.

 Social Welfare: Some firms are also inclined to take actions that they deem will
improve the overall well-being of society. These actions also tend to reduce profit.

Natural Selection
Natural selection is the notion that firms best suited to the economic environment on the
ones that tend to survive. Those firms that approximate the goal of profit-maximization,
whether intentionally or accidently, are the ones most likely to survive and remain in
business. This provides justification for presuming that business firms seek to maximize
profit, even though they might pursue other goals on a day-to-day basis. Even if firms do
NOT actively, consciously pursue the profit-maximization goal, assuming they do is not
necessarily unreasonable.

http://www.adb.org/Documents/Guidelines/Eco_Analysis/eco-analysis-projects.pdf