In the analysis of the equilibrium of a firm, an important assumption is made about the behaviour of the firms i.e. maximization profits.
The most important question is to determine output in such a way as to obtain the maximum possible net revenue. It is assumed that in a free enterprise economy goods are produced with a view to earning money. Marxian analysis will make the point quite clear.
Under simple commodity production, as pointed out by Karl Marx, the producer sells his products in order to purchase other products which satisfy his specific wants.
He starts with commodities, turns them into money, and thence once again into commodities. Commodities constitute the beginning and end of the transaction which finds its rationale in the fact that the commodities acquired are qualitatively different from those given up. Marx designates this circuit symbolically as C- M-C.
Under capitalism, on the other hand, the entrepreneur goes to the market with money, purchases commodities and then, after a process of production has been completed, returns to market with a product which he again converts into money. This process is designated as M-C-M.
Money is the beginning and the end; the rationale of C-M-C is lacking since money is qualitatively homogeneous and satisfies no wants. It is obvious that if the M at the beginning has the same magnitude as the M at the end, the whole process is meaningless.
From the standpoint of the entrepreneur the meaningful process is M-C- M’, where M’ is larger than M. The difference between M’ and M is the profit of the entrepreneur.
Therefore, the rational behaviour on the part of the entrepreneurs consists in trying to obtain the maximum possible revenue.
This is known as the principle of profit maximisation or the rational assumption. The rationality on the part of the consumer means that he attempts to maximise his utility or satisfaction; the rationality on the part of the business firm implies that it tries to maximise its profit.
The net revenue of a firm is equal to the difference between the total revenue and the total cost of production. Total revenue equals price per unit multiplied by the quantity sold. The total revenue and the total cost depend on the amount of output.
A change of output changes both total revenue and total cost and therefore changes the net revenue obtained.