Unit-5 Concept of Profit Maximization POE | BBA First Year

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Concept of Profit Maximization

• In the neo-classical theory of the firm, the main objective of a business firm is profit maximization. A company maximizes its profits only when it fulfills two rules. MC = MR and MC curve cuts the MR curve from below Profit maximization refers to the net profit that is surplus above the average cost of production.
• It is the amount left with the entrepreneur after paying all the factors of production including the wages of the management. In other words, it is a residual income over and above his normal profits.

The profit maximization situation of the firm can be expressed as:

Maximize P(Q)

Where p(Q) = R(Q)-C(Q)

• Where P(Q) is profit, R(Q) is revenue, C(Q) is cost, and Q is units of output sold. The two marginal rules and profit maximization conditions stated above apply to both a perfectly competitive firm and a competitive firm. To a monopoly firm.

Assumptions:

  The Profit maximization principle is based on the following assumptions:

1. The objective of the firm is to maximize its profits where profits are the difference between the revenue and costs of the firm.
2. The entrepreneur is the sole owner of the firm.
3. Consumers’ tastes and habits are given and stable.
4. Techniques of production are given.
5. The firm produces a single, completely divisible and standardized product.
6. The firm has complete information about the quantity of output it can sell at each price.
7. The firm’s own demand and costs are known with certainty.
8. New companies can enter the industry only in the long run. Entry of firms is not possible in the short term.
9. The firm maximizes its profit in some time frame.
10. Profit is maximized in both the short run and the long run.

• Given these assumptions, the profit maximization model of the firm can be shown under perfect competition and monopoly.

A Profit Maximization under Perfect Competition:

• Under perfect competition, the firm is one among a large number of producers. It cannot affect the market price of the product. It is a price-taker and quantity-adjuster. It can only take decisions regarding production to be sold at market price.
• Thus, the firm is in equilibrium when MC = MR = AR (price). The equilibrium of a profit maximizing firm under perfect competition is shown in Figure 1. Where MC curve intersects MR curve first at point A.
• It satisfies the condition of MC = MR, but it is not the point of maximum profit because after point A, the MC curve is below the MR curve. It does not pay the firm to produce minimum output when it can earn larger profits by producing more than OM.

• However, when it reaches OM, the level of production where the firm satisfies both the equilibrium conditions, it will stop further production. If he plans to produce more than OM₁, he will suffer a loss, because after equilibrium point B, marginal cost exceeds marginal revenue. Thus the firm maximizes its profit at price M,B and output level OM₁.
  

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Profit Maximization under Monopoly:

• Under monopoly there is one seller of the product, the monopoly firm itself is the industry. Therefore, considering the preferences and income of its customers, the demand curve for its product is downward sloping to the right. It is a price-maker who can set the price to his maximum profit. But this does not mean that the firm can determine both price and output. Either of these can work.
• If the firm chooses its output level, its price is determined by the market demand for its product. Or, if he sets a price for his product, his output is determined by what consumers will take at that price. In any case, the ultimate goal of the monopoly firm is to maximize its profits. The conditions for the equilibrium of a monopoly firm are (1) MC = MR < AR (price), and (2) the MC curve intersects the MR curve from below.

• In Figure 2, the profit maximization level of output is OQ and the profit maximization price is OP (=QA). If production exceeds OQ, MC will exceed MR, and the profit level will fall. If cost and demand conditions remain the same, the firm has no incentive to change its price and output. The company is said to be in balance.

Criticism of profit maximization Theory:

Profit maximization theory has been strongly criticized by economists on the following grounds:

1. Profit uncertain

• The principle of profit maximization assumes that companies are certain about their maximum profit level. But profit is most often uncertain because it arises from the difference between revenue realized and future costs. Therefore, it is not possible for companies to maximize their profits in conditions of uncertainty.

2. No relevance to internal organization

• This purpose of the firm has little or no direct relevance to the internal organization of firms. For example, some managers apparently spend more than would maximize the wealth or profits of the firm’s owners. It has been observed that managers of corporations emphasize the growth of the total assets of the firm and its sales as the objectives of managerial functions.
• When demand falls, managers of companies also run campaigns to reduce costs and increase efficiency.

3. No complete knowledge

• The profit maximization hypothesis is based on the assumption that all firms have perfect information not only about their own costs and revenues but also about other firms. But, in reality, companies do not have sufficient and accurate information about the conditions under which they operate.
• At best they may know their production costs, but they can never be certain about the market demand curve. They always operate under conditions of uncertainty and the profit maximization principle is weak in the sense that it assumes that companies are certain about everything.

4. Empirical evidence unclear

• Empirical evidence Unclear on profit maximization. Most companies do not consider profit as the primary goal. The functioning of modern companies is so complex that they do not think only about maximum profit. Their main problem is control and management.
• The management of these firms is done by managers and shareholders rather than entrepreneurs. They are more interested in their salary and dividends respectively. Since ownership is largely separated from control in modern firms, they are not operated to maximize profits.

5. Companies don’t care about MC and MR

• It is claimed that real-world companies do not worry about calculating marginal revenue and marginal cost. Most of them do not even know about these two words. Others do not know the demand and marginal revenue curves they face.
• Still others do not have sufficient information about their cost structure. Hall and Hitch’s empirical evidence shows that the businessman has not heard of marginal cost and marginal revenue. After all, they are not greedy calculating machines.

6. The principle of average cost maximizes profits

• Hall and Hitch found that firms do not apply the rule of equality of MC and MR to maximize short-term profits. Rather, their goal is to maximize profits in the long run. For this, they do not apply marginalist rules but decide their prices on the average cost principle.
• According to this principle price is equal to AVC+AFC + Profit Margin (usually 10%). Thus Profit maximization is the main objective of the firm Determining Price on Average Cost Principle sell your production at that price.

7. Static principle

• The neo-classical theory of the firm is static in nature. The theory does not specify a short-term or long-term period. The time horizon of the neo-classical firm consists of equal and independent time periods. Decisions are considered independent of time period.
• This is a serious weakness of the profit maximization principle. In fact, decisions are ‘temporally interdependent’. This means that decisions in any one period are influenced by decisions in previous periods, which will in turn influence future decisions of the firm. This interdependence has been ignored by the neo-classical theory of the firm.

8. Not applicable to oligopoly firm

• In fact, the profit maximization objective for the perfectly competitive, or monopolistic, or monopolistically competitive firm is retained in economic theory. But due to the criticisms leveled against it, it has been abandoned in the case of oligopoly firm. Therefore, the various objectives put forward by economists in the theory of the firm are related to the oligopoly or monopoly firm.

9. Miscellaneous Objectives

• The basis of the difference between the objectives of the neo-classical firm and the modern corporation arises from the fact that the objective of profit maximization is related to entrepreneurial behavior whereas modern corporations are driven by different objectives due to the different roles of shareholders and managers. In the latter, shareholders have practically no influence on the actions of managers.
• As early as 1932, Burley and Means suggested that managers have different goals from shareholders. They are not interested in making maximum profits. They manage companies in their own interests rather than in the interests of shareholders. Thus modern companies are motivated by objectives related to sales maximization, output maximization, utility maximization, satisfaction maximization and growth maximization.

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