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Maximization of Profit | Business Objectives | Assumptions | Arguments | Graphs


    Profit Maximization Objective of Business

    The objectives of the company are clearly defined, which are profit maximization, sales maximization, cost minimization, growth of the company, the excellence of a product, maintenance of good public relations, the welfare of employees, etc. Out of the objective mentioned above, the most important objective is profit maximization.

    The traditional economic theory assumes profit maximization as the sole objective of business firms. 

    According to the profit maximization theory, the business's objective is the generation of the largest profit. It forms the basis of price theory. Profit maximization is considered the most reasonable and analytically the most 'productive' business objective. 

    The profit maximization assumption has greater predictive power. It helps in predicting the behavior of business firms in the real world. It also predicts the behavior of price and output under different market conditions. No alternative hypothesis explains and predicates the behavior of firms better than the profit maximization assumption.

    Profit maximization is usually assumed to be the goal of the firm. However, this assumption pre-supposes that the entrepreneurs are in full managerial control of the firm, as in the case of a small owner-managed firm or partnership, and also that the owners want to achieve the highest profits that they can. If these two premises are not met, then the logic behind the assumption of the profit-maximizing firm is flawed. 

    The profit-maximizing assumption is not universally accepted. 
    Peter Drucker said that a business exists ‘to create a customer,' by which he meant that its activities were best explained in terms of marketing activity. 
    Other writers have suggested that survival is the main long-term aim. 
    Others argue that whatever may be stated as the firm's objective, the balance sheet's bottom line will always be important, that is, the profit earned.


    What is Profit?


    Accounting Profit vs. Economic Profit


    Traditionally, a firm's efficiency is measured in terms of its profit-generating capacity. Profit is an internal source of funds. Even the market value of a firm is mainly dependent upon profits earned.

    Accepting maximization of profit as the firm's objective leaves various unanswered questions, such as which profit to take (gross profit, net profit, etc.), which period of time to take into account, however, answers to all of these questions would vary from firm to firm.

    Normally profit may be stated as follows:
    Profit = Total Revenue – Total Cost

    Profit is defined differently in business and economics. The word 'profit' has a different meaning to businessmen, accountants, tax collectors, workers, and economists. 

    The two important concepts of profits that figure in business decisions are:
    1. Accounting Profit
    2. Economic profit  

    In an accounting sense, profit is the surplus of revenue over and above all paid out costs, including manufacturing and overhead expenses. Alternatively, accounting profit is the difference between total receipts and the explicit (accounting) costs of carrying out the business. Explicit cost is the payments made to the hired factors of production. Accounting profit does not take into account the implicit cost.

    Accounting profit is calculated as follows.

    Accounting profit = TR- (W+R+I+M)
    where, 
    W= Wages and salaries
    R = Rent
    I= Interest
    M= Cost of materials


    Profit Maximization Theory


    Economic profit is also known as pure profit or just profit. Economic profit takes into account the implicit or imputed costs too. The implicit cost is the opportunity cost. Opportunity cost is defined as the income foregone, which a business person could expect from the second-best alternative use of his resources. The economic profit is the residual after both the explicit and implicit costs are deducted from the total receipts. 

    Economic profit or pure profit makes provision also for:
    (a) Insurable risks
    (b) Depreciation 
    (c) Payment of necessary minimum amount to shareholders to prevent them from exiting from the company

    Pure profit is the residual left after all contractual costs are met. These include the transfer costs of management, insurable risks, depreciation, and payments to shareholders sufficient to maintain investment at its current level. 

    Pure profit= Total revenue - (explicit costs+ implicit costs)

    Pure profit may not necessarily be positive for a single firm in a single year. It maybe even negative, since it may not be possible to decide beforehand the best way of using the resources. Besides, pure profit is considered to be a short - term phenomenon in economics. Economic profit does not exist in the long run, particularly under perfectly competitive conditions.

    Profit Maximization Conditions


    According to conventional economic theory, a firm aims to maximize its profit. It is in equilibrium when it maximizes profits. Here, we examine the profit-maximizing output decision of a firm. This analysis will hold irrespective of whether the firm is operating under conditions of perfect competition or in a situation where there is some control over price.

    The firm’s economic profit is the difference between TR and TC.

    P = TR - TC
    where,

    P = Total economic profit, which a firm attempts to maximize while making its decision about the output level and the price of the product

    TR = Total revenue, It is calculated as price multiplied by the quantity sold or TR = P × Q

    TC = Total cost, It is calculated as the sum of total fixed cost and total variable cost or TC is Total fixed cost + Total variable cost.

    For the profit maximization, two conditions need to be satisfied at the equilibrium point:


    (i) First-Order or Necessary Condition: It is necessary that Marginal Cost (MC) equals Marginal Revenue (MR).

    (ii) Second-Order or Sufficient Condition: The MR should be falling while the MC should be rising.

    MC is marginal cost which is the addition to the TC as the output level is raised by one more unit.
                            =    (TC)
                                     Q

    MR is Marginal revenue which is the addition to the TR, when an additional unit of the output is sold.
                           =   ∂(TR)
                                   ∂Q

    First-order condition-


    The first-order condition of maximizing a function is that its first derivative must be equal to zero. Differentiating the total profit function(P= TR-TC) and setting it equal to zero, we get

     ∂(TR)  -  ∂(TC) = 0
    ∂Q     ∂Q               ∂Q

    or      TR   =   TC
               ∂Q          ∂Q

    Slope of TR= Slope of TC

    i.e., MR=MC

    The first-order condition is generally known as necessary condition. A condition is said to be necessary if its non-fulfilment results in non-occurrence of an event.

    Second-order condition-


    The second derivative of the total profit function is: 

    ²P   = ² (TR)  -    d² (TC)    
    ∂Q²        ∂Q²             ∂Q² 

    The second-order condition requires that

       ²(TR)    <      ²(TC)     < 0
        ∂Q²                  Q² 

    or,  ²(TR)    <    ²(TC) 
             ∂Q²                Q² 

    Since ²(TR)/∂Q²  is the slope of MR, and
     ²(TC)/ Q² is the slope of MC, 
    the second order condition may also be written as

    Slope of MR < Slope of MC 

    This proves that MR should be falling while the MC should be rising.


    Profit Maximization: Graphical Representation


    Total Approach


    Profit Maximization: Total Approach


    • Between the origin and the output level OQ1, the TC curve is above the TR curve. Hence, there occurs negative profit or losses.
    • The firm will make zero profits at the output level of OQ1 and OQ2. These are called the Break Even Points. Here, there is no difference between TR and TC curves.
    • The firm will maximize the profits at the output level of OQ. 
    • Between the output level OQ and OQ2, the TC curve is rising more rapidly than the TR curve. Thus, the profit curve is declining.
    • Beyond the output level OQ2, the TC curve is again above the TR curve. Hence, there occurs negative profit.


    Marginal Approach


    A firm chooses that level of output at which
    (i) MR = MC.
    (ii) Slope of MR < Slope of MC or the MC curve cuts the MR curve from below.


    Profit Maximization: Marginal Approach


    • The firm will maximize the profits by producing that level of output at which MR is equal to MC. This occurs at two points, F and G. But it is only at point G that the second condition, the MC curve cuts the MR curve from below is also satisfied. Point G corresponds to OQ2 level of output. At point F, the MC curve cuts the MR curve from above and thus at OQ1 level of output the firm is not maximizing the profits.
    • For output levels less than OQ2, MR is greater than MC. Hence, the addition to the TR is more than the addition to the TC. Since the firm will be adding more to TR than to TC, its profit will increase. Thus, the firm must increase its output.
    • For output levels greater than OQ2, MR is less than MC. Hence, the addition to the TR is less than the addition to the TC. Since the firm will be adding more to TC than to TR, its profit will decrease. Thus, the firm must decrease its output.

    Profit Maximization Assumptions


    Assumptions made in theory :

    1. The traditional theory of the firm’s behavior assumes that the objective of firm owners is to maximize the amount of short-run profits.
    2. The company is run by its owner.
    3. The companies actions are rational in pursuing its goal. It always selects an alternative that helps it to achieve profit maximization.
    4. All the relevant variables are known at the time of decisionmaking.
    5. The market conditions are known.
    6. The company transfers the inputs to the high value of outputs, given to the state of technology.

    Arguments Against the Theory of Profit Maximization


    This traditional theory has been criticized on the following grounds:

    1. Not all companies need to have profit maximization goal. They may have a goal of sales maximization, expansion of the market, etc.
    2. Most of the companies in the present day are not run by the owners or shareholders, but by the salaried managers. The aims of the managers differ from those of the owners. The assumption of the one-person company is outdated in this century.
    3. Decision-makers cannot always make rational decisions because of the lack of perfect knowledge of all relevant variables.
    4. To avoid competition, sometimes companies enter into agreements. In such cases, this theory cannot be applied. Such agreements are common in automobiles, aircraft, soaps, detergents, chemical industries, etc.
    5. It has been observed that a few large companies are generally dominating the market. In such cases, small companies have to follow these large companies in fixing the price. In such circumstances, companies cannot follow this theory.
    6. Profit maximization is done on the basis of cost figures, but if the cost figures are higher than those it should be due to inefficiency, then the price fixation is bound to be incorrect.
    7. Modem companies have a departmental system of working, where each department is making decisions related to them. These decisions may or not lead to the overall optimization of profit.

    Arguments in Favor of Profit Maximization Theory


    The conventional profit maximization theory is defended on the following grounds:

    1. An argument in favor of this objective is that profit is a must for the long-term survival of business.
    2. The achievement of alternative objectives, such as maximization of the managerial utility function, maximization of long-run growth, maximization of sales revenue, satisfying all the concerned parties, increasing and retaining market share, etc., depends either wholly or partly on the primary objective of making a profit.
    3. When compared to other business objectives, profit maximization assumption has a more powerful premise predicting certain aspects of a firm's behavior. Milton Friedman supported profit maximization on the ground that opinions of some executives cannot judge its validity; rather, its ultimate test of validity is that it has a greater ability to predict future business trends and practices. 
    4. Although it is not perfect, profit is the most efficient and reliable measure of the efficiency of a firm. It is also the source of internal funds. Profit as a source of internal finance assumes a greater significance when the financial market is highly volatile. 
    5. Whatever one may say about the firm's motivations, if one judges their motivation by their acts, profit maximization appears to be a more valid business objective.

    Conclusion


    Profit is not the only goal; it is usually dominant because the survival of the company depends on it. The business has multiple goals. Sometimes for survival, goodwill, security, or growth sacrifices of short term profits have to be made. 

    The businesses also must have their own objectives, decided to satisfy the needs of different groups like shareholders, managers, customers, and employees, whose cooperation is necessary for the continued existence of the company.




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