economics

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Why Do Firms Want To Maximize Profit

This report aims at examining the different views on why firms are run, what firms are run for and economists view on this report will be analysed. The report will be looking briefly at different firms, both large and small, companies and cooperatives, limited and unlimited liability firms and to criticise the viewpoint on the topic, will be looking at non-profitable organisation. This study researches why it is important that firms make the most profit they can and other alternatives to maximizing profits. The materials used to source data for this study are: articles, journals and textbooks.

Types Of Firm

A ‘firm’ is a designation under which a company operates and transacts business. We have small firms which comprises of sole-proprietorship, partnership and cooperative and large firm comprises of companies and multi-national firms. These firms will be distinguished by their legal status:

Sole proprietorship: is a business solely owned by one person. All profits made goes to him.

Partnership: is a type of business owned by two or more people. They share their profit as stated in their articles of association.

Cooperative: is a firm owned by their workers, they all share profit equally.

Companies: a company is legally separated from its owners. Any debts are the company’s debt and not its owners’. Investment in companies yield dividend for shareholders.

There are two types of companies, they are:

Public limited company: this is a nationalised industry and can offer share to the public. and

Private limited company: its shares are only traded within members of the company

Public corporation: these are state owned enterprises. Examples are BBC and Bank of England.

There is a common feature with all the types of business listed above, ‘PROFIT’, in order to examine the assumption of profit maximization, we need to understand what profit is, to have profit is to have gain after a firm’s sales revenue has been deducted from all expenses incurred, mathematically, profit =TR-TC where TR is total revenue and TC is total cost (Brian et al, 1998). Why is profit important? Profit create incentives, provides source of revenue to acquire more equipment and it encourages innovation. For profit to be maximized, the point of maximum difference should be corresponded to output level X which is the profit maximising output. At this point, the slope of the total revenue curve is marginal revenue (MR) and the slope of the total cost curve is marginal cost (MC). In order to Maximize profit, costs must be minimized which means that the amount of each input will be determined by its marginal production equals to its cost. Thus, profit maximization requires that MC=MR. This is represented in the diagram below:

Motives For Running A Firm

The main objective traditionally attributed to firms by neo-classical economic is to maximize profit. In a public limited company, the shareholders are separate from the firm, the motives and aims for both shareholders and directors are different. The shareholders might want to make profits to be able to increase their dividends whereas a manager may pursue different aims, like utility maximization or sales maximization, in regardless of all the types of firms, the owners of all these firms want to run the business in order to achieve the highest income for themselves as much as they can and same goes for the large firms, the shareholders want to achieve the greatest maximum profit. The operational objective for the management of a firm is to maximise the difference between operational receipts and operational expenditures plus investment, whilst minimising risk. Motives for running a firm range from achieving monetary gain to enhancing status and to establish a comfortable working environment. Almost all, if not all profit based organisation aim to make as much profit as it can.

Other alternative theory of firms is to maximise growth of the firm by increasing sales and market power and maximising welfare and having more managerial power. For a firm operating a monopolistic market, it can focus on profit maximization but a competitive market type can find it difficult to maximize profit. A competitor and a monopolist have one thing in common, that is to maximize profits.

Economist Views On Profit Maximization

Economists (Friedman, 1970) have traditionally based their analysis of business activity on the assumption that its prime goal is and should be profit maximization, but some economists argue that profit is not the only force that brings firm into existence, but also the force that allocates resources, (Marxist economic) criticise the Keynesian theory of profit maximization.

For small firm, the entrepreneur is greatly motivated by profit maximization, if the entrepreneur’s profit falls below minimum acceptable level he might cease to produce goods and services and he might eventually cease to trade, but the entrepreneur take risks by spending time and developing skills to run the firm efficiently, profit is the reward of the risk the entrepreneur is taking (ibid). Economists, Adam Smith (1776) further argue that all firms have to maximise profit because they see profit maximization as the only feasible goal and for a firm to expand it has to maximize its profit to generate funds because most firms do not run its business in charitable trust except for non-profitable organisations. As Young (1930) famously asks, “if not for profit-for what”?

Non-Profitable Organisations

Non-profitable firm is a firm that exists to improve the general welfare of the society through the proper utilization of appropriate resources. Not for profit firms can still achieve their aims and objectives accurately by using some of the same methods developed in for profit enterprises like: organising, accounting, affective and efficient management. Examples of non-profitable firms are: clubs, churches, charities, schools, unions, association and societies. Non-profitable firms focus on the difference they could make in the communities by thinking and acting in new ways to work within the pressure of the environment. Funding is a very vital and necessary pre-requisite which means that not for profit firms still need revenue to run its firm.

There are similarities between non-profit organisations and for profit organisation. A non-profit organisation faces the same problems as a for profit organisation e.g. supply curves for resources, demand curve for output and production function, but the visible difference between both organisations is that one insists is goal is to make profit and therefore is forced to produce high quality of goods and services, while the goal of a non-profit organisation is to render goods and services to someone and it is forced to cover its costs.

Why Do Firms Want To Maximize Profit?

A firm is an asset, and its owners will be interested in increasing the value of this asset over time, one way by which firm increases its value is by profit maximization. A firm has to pay for its labour, raw materials and equipment so revenue obtained influence the continuity of the firm. (Friedman 1970) argues that the social responsibility of a business is to maximize its profit. Profit is not the only force that brings firms into existence, but also the force that allocates resources, when a firm makes profit, it can reward its employees with greater salaries, bonuses and higher dividends for the entrepreneur. Profit can also be used to finance investment in expanding the company. (Richard Posner) argues that a firm that does not maximise its profits is weakening its effort in competing with other firms so some firms use profit maximization to drive their competitors out of business. In the present economic downturn, profit could be an option a firm can fall back on. Though, there are times that firms will not pursue profit maximization because the workers might not have the same objective as the firm, the employee can pursue other objectives like status and job satisfaction while firm is more concerned about the society, environment and general well being of their employees, but all these other objectives are still alternative ways to increase profits which still comes down to profit maximization.

Conclusion

To say that, “all firms, in the end, are run to make the most profit they can” (Fuller, 2009) will be generalising all firms because not all firms are run to maximize profit, but most firms. The assumption that firms attempt to maximize profit is inconsistent with the underlying methodology of micro economics which assumes that all decision makers are individual (ibid), shareholders, managers, entrepreneur and all their objectives are different. In reality, the goals and objectives of a firm are broader that profits alone.


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