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Profit maximization basic objective of firm?

A firm's main objective should be to make decisions that maximize the value of
the company for its owners, and as the owners of a company are its
shareholders, the main financial objective should be 'the maximization of
shareholder wealth'.
Since shareholders receive their wealth through dividends and capital gains,
shareholder wealth will be maximized by maximizing the value of dividends and
capital gains that shareholders receive over time.

Problems with the 'maximization of profits' objective:

Firstly, there are quantitative difficulties associated with profit. Maximization of

profits as a financial objective requires the profit to be defined and measured
accurately, and that all the factors contributing to it are known and can be taken
into account. It is very doubtful that this requirement can be met on a regular
E.g- If 5 auditors go into the same company, it is very likely that each will come
out with a completely different profit figure.

A second problem concerns the timescale over which the profit should be
Should profit be maximized in the short term or the long term?? Given that profit
considers one year at a time, the focus is likely to be on short-term profit
maximization at the expense of long-term investment, putting the long term
survival of the company into doubt.
There are many examples of companies going into liquidation shortly after
declaring high profits. Check out - Polly Peck Plc's dramatic failure in 1990! (good

The third problem is that profit does not take account of or make any allowance
for risk! It would be inappropriate to concentrate efforts on maximizing
accounting profit when this objective does not consider one of the key
determinants of shareholder wealth.

So the 'maximization of profit' is not a suitable core objective for a company.

That is not to say that a company does not need to pay attention to its profit
figures, since falling profits of profit warnings are taken by the financial markets
as a sign of financial weakness.
Instead these sort of profit targets/objectives should can serve a useful purpose
in helping a company to achieve short-term or operational objectives within its
overall strategic plan.
Examine critically profit maximization as the objective of business firmeven if
profit maximization is the most important objective what is the relevation of
other alternative business objectives?

Thoeries underlying the Objective of a Firm, mainly talk about the subject of
Ethics in Business.
Debate is going on since a long time, as to whether every Firm's Objective needs
to be ETHICAL?
the answer may seem as simple as "YES", but the counter arguements that
follow are difficult to answer.

Does a Cigratte Manufacturing Company have an ethical objective? Are Liquior

Producers into Ethical Business?
These Companies thrive at the cost of Consumer's Health. Nevertheless they are
highly Profit Making.

Coming to Profit Maximization, the question goes as to whether Profit

Maximization Goal is justitfied?
In a private enterprise, no one can have control over Profit maximization. If the
profits are made with the use of Society's resources, such profits need to be
sowed back for Societal Development.

Abnormal Profits/Supernormal Profits indicate the presence of Monopoly, new

entrants and market expansion can keep a check on Monopoly, which is a matter
of time.

Economic theory is based on the reasonable notion that people attempt to do as

well as they can for themselves, given the constraints facing them. For example,
consumers purchase things that they believe will make them feel more satisfied,
but their purchases are limited (at least in the long run) by the amount of income
they earn. A consumer can borrow to finance current purchases but must (if
honest) repay the loans at a later date.

Business owners also attempt to manage their businesses so as to improve their

well being. Since the real world is a complicated place, a business owner may
improve his well being in a number of ways. For example, if the business doesn't
lack customers, the owner could respond by reducing operating hours and
enjoying more leisure. Or, the business owner may seek satisfaction by earning
as much profit as possible. This is the alternative we will focus on in class - for a
very good reason. If a business faces tough competition, the only way the
business can survive is to pay attention to revenues and costs. In many
industries, profit maximization is not simply a potential goal; it's the only feasible
goal, given the desire of other businesspeople to drive their competitors out of
In economic terms, profit is the difference between a firm's total revenue and its
total opportunity cost. Total revenue is the amount of income earned by selling
products. In our simplified examples, total revenue equals P x Q, the (single)
price of the product multiplied times the number of units sold. Total opportunity
cost includes both the costs of all inputs into the production process plus the
value of the highest-valued alternatives to which owned resources could be put.
For example, a firm that has $100,000 in cash could invest in new, more
efficient, machines to reduce its unit production costs. But the firm could just as
well use the $100,000 to purchase bonds paying a 7% rate of interest. If the firm
uses the money to buy new machinery, it must recognize that it is giving up
$7000 per year in forgone interest earnings. The $7000 represents the
opportunity cost of using the funds to buy the machinery.

We will assume that the overriding goal of the managers of firms is to maximize
profit: P = TR - TC. The managers do this by increasing total revenue (TR) or
reducing total opportunity cost (TC) so that the difference rises to a maximum.
An Example

Suppose you are running a business that produces and sells office furniture. It's a
small operation, and in a typical day you produce three custom desks. You are
able sell these desks for $500 apiece. You employ five workers, each of whom
earns $15 per hour ($120 per day), and you work alongside them and pay
yourself at the same rate. Material inputs cost $150 per desk. Of course, you
have additional "overhead" expenses, including rent, a secretary/bookkeeper,
electricity, etc. This overhead, which we will assume does not vary with the
number of desks produced (i.e., it's a fixed cost) comes to $130 per day. Thus,
your company earns a profit of P = ($500 x 3) - ($720 + 450 + 130) = $1500 -
$1300 = $200 per day. (Wages for six workers come to $720. Materials for three
desks cost $450. Overhead is $130.) Working five days a week for 50 weeks a
year, that comes to an annual profit of $50,000. Pretty nice - but could you do

Suppose you decide to increase production to four desks per day. This requires
you to hire two more workers (at another $240) and purchase another $150
worth of materials. Overhead expense doesn't change. Your total cost rises to
$1690. You find that you are able to sell the fourth desk for $500. Was this a
good decision? [Engage brain here.]

You're right. [I'm giving you the benefit of the doubt here.] Total revenue rises to
$2000 per day, while total costs rise to $1690. Profit increases to $310 per day.
Good show, old man/woman/[insert desired politically correct term here]!

This nice result may lead you to increase production to five desks a day. If you
are able to sell all five desks for $500 each, and if your variable costs of
producing the desks - what you pay in labor and materials - doesn't increase,
producing a fifth desk makes sense. TR rises to $2500, TC rises to $2080, and
profit increases to $420. So you sell five desks.

Suppose, however, that you find that the labor market is so tight that you cannot
hire another two workers at $15 per hour. In fact, to hire your ninth and tenth
workers, you must pay $20 per hour. That increases the labor cost of the fifth
desk by $80 ($40 per worker times two workers). TC rises to $2160, which still
allows profit to increase to $340. But we have a problem brewing. Can you really
get away with paying your veteran workers $15 an hour, while at the same time
hiring new workers at $20 per hour? Not likely. So when you hire the ninth and
tenth workers, you are forced to raise the wages of your first eight workers (Pay
yourself more; hey, you deserve it.). Let's recalculate profit for Q = 5. TR = $500
x 5 = $2500. TC = ($160 x 10) + ($150 x 5) + $130 = $2480. That leaves a
profit of $20. Doesn't look like such a good idea now, does it Einstein? Thus, if
you realize that your costs will rise sharply if you produce a fifth desk each day,
you will decline to produce the desk.

Our little example illustrates the situation every business owner or manager
faces. Businesspeople know what their current position is (revenue and costs)
and they can estimate TR and TC for a higher (or lower) level of production. By
actually changing output levels, they learn by experience what their demand and
cost curves look like. In the process, they discover what happens to profit as they
change output levels. Through this discovery process, businesspeople seek to
find the output level that maximizes profit.

As omniscient onlookers, we can describe this process a bit more analytically. A

firm should increase its output so long as the marginal revenue earned from
additional units of production is greater than the marginal cost of those units.
Marginal revenue is the additional revenue earned by selling one more unit of a
product. (In our example, MR = $500.) Marginal cost is the additional cost
incurred in producing one more unit of output. So long as MR > MC, profit grows.
However, when MR < MC, profit shrinks. So firms expand output only to the point
at which MR = MC. This point maximizes profit.

The profit-maximization rule applies both to firms that are able to sell their
product at a constant price (as in our example) and to firms that find they must
reduce the price of their product to increase sales. In the real world, firms have
to engage in trial-and-error discovery processes, searching for the profit-
maximization point. But the process can be succinctly described by the marginal
revenue-marginal cost rule.