The profit maximising firm
The profit maximising firm
Since the 12th century and the escalation of separate owner / managed business organizations, the assumption that firms maximises profits has been at the forefront of economic theory. Cyert and Hedrick (1972) stated:”The unmodified neoclassical approach is characterised by an ideal market with firms for which profit maximisation is the single determinant of behaviour. Thus predictions can readily be made by combining the description of the market with the results of maximisation of the relevant Lagrangian.”In recent years their has been extensive literature by economists questioning the theory of profit maximisation, given that the standard “theory of the firm” is based upon rigid assumptions which can only exist in a perfect market.
Tollison (2003) stated:’The debate about whether firms maximise profits serves as a purpose of forcing scholars to be more careful in framing maximisation hypothesis, and as a consequence, the profit-maximisation hypothesis is basically a non-issue today.”Perhaps the most controversial assumption that compromises the neo-classical hypothesis is that firms always maximises profits (and minimise costs). This is further explored by incorporating more recent managerial models in particular Baumol.
There are however a number of other generic managerial criticisms of the Neo-classical model, all of which have been widely investigated by economic literature.
The first criticism concerns the inevitable conflict of interest between management and shareholders. In the modern economy, where ownership and control of firms often lie with different groups of individuals economists have found that each stakeholder group has conflicting objectives, regarding the use of resources by the organisation.
Managers employed by companies have a contractual relationship with the owners of the company i.e. they are the shareholders agents. However if the interests of shareholders and managers differ, then management are likely to be selective in the information they provide to their shareholders, resulting in managers having discretion to peruse their own objectives which may not be profit maximising; thus not conforming to the Neo-classical profit maximising model.
Friedman (1980) found that individuals always follow their own interests depending on what they value and what goals they wish to pursue, thus the assumption that individuals act rationally may be viewed as ignoring important aspects of human behaviour. In order for a firm to profit maximise all parties must hold the same values and goals, which is extremely unrealistic, with the exception of an owner managed sole business.
Another managerial criticism of the theory of profit maximisation is the existence of natural constraints within in the market (forces of demand and supply) and rules and regulations imposed by third parties such as the government (trading quotas, tax etc.). These limit the ability of firms to maximise profits, e.g. The Canadian government controls its domestic alcohol industry by price, distribution and trading cap’s, thus taking away a firms ability to maximise profit in comparison to a perfect marketplace.
Today’s increased emphasis on social responsibility to limit negative externalities provides another barrier for firms wishing to profit maximise. Amaeshi (2005) highlighted that the rise of social responsibility helps strengthen the already prevalent view that the pursuit of profits is wicked and immoral and must be curbed and controlled by external factors.
The direct conflict between profits and morals has had a large impact for today’s economy in particular petro-chemical, pharmaceutical and energy industries. One such example is Huntingdon Life Sciences, which has been directly forced to change its strategy of profit maximisation and concentrate on increasing sales, primarily due to being targeted by animal protestors which resulted in its capital funding being severely restricted.
Neo-classical models are also criticised for their short term perspective. In the long run the objectives of a profit maximising firm is said to be the maximisation of shareholder wealth, which is achieved by maximising the firms value. However profit maximising models rely on short term modelling, which in itself implies that profits for one period depend upon profits for another, which may create conflict between the two objectives.
Finally neo-classical economics rely heavily on complex mathematical models, in an attempt to model the modern economy. Realistically the nature of today’s evolving economy means it’s completely unfeasible to use outdated calculations to try to evaluate and predict firm’s objectives in an evolving market, whether profit maximising or not.
In order to investigate the relevance of profit maximisation in today’s society it is necessary to compare and contrast the Neo-classical profit maximising model with more recent managerial models in particular Baumol.
Figure 1. Diagram to illustrate the Neo-Classical model. (Source: Author)Figure 1 illustrates the standard Neo-Classical approach. Profit maximisation occurs when the marginal cost [MC] of producing an additional unit equals the marginal revenue [MR] from the sale of an additional unit.
In the Neo-classical model, the goal of the firm is to maximise profits, assuming that sales volume and output are always equal. In imperfect competition the firms market power enables it to face a downward sloping demand curve allowing it to set a price of Pm at a quantity of qm, regarded as profit maximising (MC=MR) [X1].
Recent literature regarding modern economies indicates that the Neo-classical model is unsatisfactory in predicting the impact environment changes will have on the firm. Rothbard (1993) stated that:”In reality firms face constraints both with the physical nature of production (the production function) and costs (due to the production function and input prices), all of which are a ‘given’; in the neo-classical theory of the firm”.
Therefore it is necessary to compare and contrast with recent managerial models in particular Baumol.
Baumol discretionary theory is based on the model of a firm with given assets, high management and an external market environment which is, monopolistic, oligopolistic or imperfectly competitive. Therefore management is effectively responsible for three decisions, namely, price, marketing expenditure and their own remuneration, all of which impact the wealth of the shareholder.
Baumol (1967) stated that his own observance of firm behaviour demonstrated that a firm’s management often would seem more interested in total revenue or sales.
“Though businessmen are interested in the scale of their operations partly because they see some connection between scale and profits, I think management’s concern with the level of sales goes considerably further. In my dealings with them I have been struck with the importance the oligopolistic enterprises attach to the value of their sales. A small reversal in an upward sales trend that can quite reasonably be dismissed as a random movement sometimes leads to a major review of the concern’s selling and production methods, its product lines, and even its internal organizational structure”In Baumol’s model, the role of the firm is to maximise sales revenue.
Figure 2. Diagram to illustrate Baumol managerial model of sales revenue maximisation. (Source: Author)In Figure 2. Baumol assumes that firms operate in a market of imperfect competition (where the demand curve is downward sloping) but the firm does have limited control over price and output. However due to the level of uncertainty of demand or the reliability of the marginal costs of their output, firms choose an output and price set to a level which maximises revenues (MR = 0) [X3].
In Baumol’s model the firm can set its price to the point that profit is zero, in order to maximise sales revenue, this contradicts past Neo-classical theories of profit maximising [MC=MR], which would occur at X4. Setting a price potentially where profit is zero isdue to the uncertainty of today’s economy where firms would rather maximise revenue, than attempt to profit maximise.
If Baumol’s assumptions hold true in direct comparison to traditional models then: output should be higher, profits should be lower and prices should be lower for the revenue maximising firm.
In order to fully understand the implications of both models it is beneficial to relate them to today’s economy, in particular to Sandals Caribbean Resorts and Thomson Holidays, a division of TUI UK Ltd.
Generally Sandals is regarded to operate at the higher end of the market specialising in luxury exclusive holidays, whereas Thomson mainly targets the lower to middle market spectrum. Every year Thomson and Sandals have a fixed amount of holidays available within their resorts.
Out of the two firms operating in the same industry Sandals is likely to try and emulate the traditional Neo-Classical model of profit maximisation, by operating at MC=MR. As a result Sandals wouldn’t concentrate on filling every place but by charging a higher price Pneo, at the lower quantity qneo they would maximise profits. Assuming that the holiday industry is an imperfect market this would occur at point X4 in figure 2.
Baumol’s (1967) theory contradicts the traditional Neo-Classical model emulated by Sandals stating that it would be impossible for Sandals to continually operate at X4. This is due to evolving market constraints creating uncertainty for their demand and the lack of reliability in calculating the marginal cost of their output.
In reality Sandals would operate between the Neo-classicalprofit maximisation model and Baumol’s revenue maximisation model, that is they would wouldn’t compromise their core competencies (luxury, exclusivity) in the desire to maximise revenue. If however demand was low, threatening the effectiveness of profit maximisation then they may stimulate their demand curve (discounts, advertising etc) in order to increase sales and therefore increase revenue.
Thomson on the other hand is more likely to follow Baumol’s model, by concentrating on filling all its resorts to try and achieve point X3 on figure 2. In some instances according to Baumol, Thomson could manipulate the demand curve by dropping prices to an extent where they create demand. Thomson is likely to follow this model to such a degree that in some cases it may result in a position below where MC=MR, i.e. discount prices to an extent where all resorts are fully utilised, e.g. last minute holidays. In the long run as a principle objective this isn’t a viable option, as poor management control would create the situation of MC being greater than MR, resulting in a loss.
Many of the constraints which affect Thomson and Sandals’s demand curves are out of their direct control. An example of such is the weather; if in the UK it is forecasted to be particularly good then customers may choose to remain at home thus causing the demand curve to drop. Another example of particular relevance today is the risk of terrorism, in recent years customers have chosen to stay away from Egypt, America etc, thus decreasing demand. In order to profit maximisation firms must be able to accurately predict demand at every point in time; Baumol’s model highlights that such a feat is impossible and in reality MR=0 is a feasible alternative. As a result profit maximisation firms [British Airways and Sandal in the past] have had to compromise their positions of profit maximisation and move toward maximising revenue.
Thomson and Sandal also face uncertainty in establishing their MC curves. The main hindrance is due to the holiday industry predominately operating abroad; therefore firms struggle to establish their MC due to currency fluctuations, changing fuel surcharges etc. Without being able to establish its MC curve Sandal would be unable to profit maximise. Thomson would also have difficulties but to a lesser extent in ensuring that they where operating at a point that MR≥0.
Baumol’s revenue maximising theory has provided economists with a more realistic model to evaluate firm’s behaviour; however there is one major weakness which affects both it and profit maximisation; neither takes time into consideration. This undermines Baumol’s main advance of the Neo-classical model, regarding the role that uncertainty plays in the revenue maximising hypothesis, thus failing to consider that uncertainty exists precisely because of the existence of time.
In 1993, Rothbard presented a model taking account of time and the assumption that the producer always has the most up to date information.
Rothbard model agrees with all the basic principles of Baumol, in that firms seek to maximise revenue, Rothbard also reflects that when it is time to sell the final product, all previously-incurred costs must be regarded as sunk costs, as by their very nature they can not influence the price of the final good. However, Rothbard also has weaknesses, as such an assumption excludes a basic economic principle that production costs occur before sales. In terms of Thomson and Sandal this would imply that their would be an increased level of uncertainty for each constraint discussed above, thus their being less chance of successfully predicting their demand and MC curves, especially for profit maximisation.
To conclude, in the past the Neo-classical profit maximising model was wildly used within the field of economics to explain firm’s behaviour; however economists have found it to contain a number of flaws regarding what actually occurs in reality for the firm’s pricing and output decision making process.
A number of models have been presented in order to improve the standard neo-classical model. Baumols model analyzed the workings of the firm in the real world; discovering that due to uncertainty firms are likely to maximise revenue, by setting a price lower and output higher than standard profit maximising. However on investigation, Baumols model was also found to have weaknesses, the absence of a time factor which would undermine its uncertainty. Further developments have taken place in the field such as Rothbard’s model, however similar to Neo-Classical and Baumol their also exists limitations. Therefore it can be stated that in today’s evolving markets it is unlikely that any economic model will ever be able to provide a complete insight into pricing and output decisions that management face.
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