Do firms always profit maximise?

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Mo Tanweer, Head of Economics, Oundle School.

The conventional assumption in most economic models is that firms profit maximise.

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But, this may not reflect reality.• C

Profit maximisation is where Marginal Costs equal Marginal Revenue.

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Profit maximisation

In other words, where the marginal profit is zero.• C

But profit maximisation may be sub-optimal for firms because of constraints that prevent them achieving it, or because circumstances mean it may actually be undesirable.

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In reality, firms have a range of objectives which they wish to pursue, of which profit maximisation is just one.

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This is a term coined by economist Herbert Simon in 1948, combining ‘satisfy’ and ‘suffice’.

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He said that: “Whereas economic man maximises, selects the best alternative from among all those available to him, his cousin, administrative man, satisfices, looks for a course of action that is satisfactory or ‘good enough.’”

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Profit satisficing is the idea that aiming to maximise profit may be unrealistic due to bounded rationality.

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Satisficing

Firms will aim to make some minimum level of profit (to survive or please shareholders) and then move to focus on other aims such as social responsibility.

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This can be defined as “actions that appear to further some social good, beyond the interests of the firm and that which is required by law.”

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Pharmaceutical company Merck, for example, has an agreement to not assert its patent on the HIV/AIDS drug Stocrin in South Africa.

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Also, 200 firms in London have signed a voluntary agreement to pay above the National Minimum Wage.

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Corporate socialresponsibility

Either all firms are not driven by profit concerns and some do focus on social responsibility or they may be subscribing to the Efficiency Wage Hypothesis.

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This states that wages above the market clearing wage rate create an incentive for workers to increase their productivity, prevent shirking and reduce hiring and firing.

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Thus higher nominal wages can actually lead to lower relative unit labour costs and higher profits – coming back to profit maximisation.

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Only in small independently-owned firms where the owner is the manager, can the focus be purely on one objective.

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Larger companies are a coalition of interests and thus actually aim to satisfy different people, adopting a mix of objectives.

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Some firms may not desire profit maximisation because of the power of certain stakeholders and ownership structure can affect the objectives firms adopt.

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Behavioural theories

Facebook CEO, Mark Zuckerberg stated publicly in 2013: “Simply put, we don’t build services to make money; we make money to build better services.” Facebook was “built to accomplish a social mission – to make the world more open and connected.”

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Firms can only continue to exist if some level of profit exists.• C

But many firms do not make profit in the early stages of their existence and this is particularly true of technology start-ups.

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For example, Skype, a firm created in 2003, was still operating at a $7m loss when it filed for an IPO in 2010.

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What does it depend on? 1) The time frame

Thus profit maximisation may be a relevant long run objective, but not possible in the short run.

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In the short run it may be preferable to run at a loss and aim for revenue maximisation or establishing a brand presence and aim for growing market share.

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Similarly, in a recession it may not be the best time to pursue profit maximisation.

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A monopoly firm lacking competition may have no incentive to maximise profit whereas oligopolistic firms may, given the performance of their rivals.

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But in oligopolistic industries, firms have so many stakeholders to consider, that profit satisficing is a more realistic aim.

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Also, small firms may be concerned primarily with survival, and short run profits could be critical in this.

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What does it depend on? 2) The market structure

The luxury of being able to wait for deferred long term profits may only be the preserve of established multinationals.

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It is generally accepted that firms in the private sector are more likely to pursue profit maximisation than those in the public sector.

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The lack of accountability in state agencies prevents the need for cost minimisation.

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As for charities, a ‘not for profit’ charity simply means that surplus revenues are used to achieve its goals rather than be distributed to owners.

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What does it depend on? 3) The type of firm

But given their aim to maximise the amount they can give to their cause, donations minus administrative costs, this is similar to profit maximisation.

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Some schools operate as charities whilst others are for-profit institutions.

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Also, universities spent ￡ 591m on bursaries between 2006 and 2008, and this is not consistent with profit maximisation but instead social responsibility goals.

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There may be another self-interested reason why firms may choose to profit satisfice.

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In a bid to avoid attracting the attention of regulators, firms may wish to not try to profit maximise to extremes.

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In October 2013 when all gas firms in the UK tried to increase prices to maintain profit margins, pressure from MPs caused a partial U-turn on proposed price hikes over the Christmas period.

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What does it depend on? 4) Avoiding the regulator.

By not maximising profits, firms can stay ‘under the radar’ of the regulators like the OFT and away from the anger of consumers.

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Some firms may wish to profit maximise in a first best world, but cannot in the second best reality.

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It is near impossible to determine price-output decisions in the manner suggested by economic theory.

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The Issue may be imperfect competition as many self-employed may have no understanding of the concepts of MR and MC curves.

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What does it depend on? 5) Imperfect information

Or there may be practical limitations in measuring these.• C

Thus many firms adopt a ‘cost-plus pricing’ strategy to ensure simply that a loss is not made on the unit sold.

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It allows for a starting point.• C

Firms can only survive if they make a profit and most will aim for this in some way.

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Both Alfred Marshall’s concept of Perfect Competition and William Baumol’s concept of Contestability were not meant to state reality but to offer a model from which to compare real world behaviour.

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So why assumeprofit maximisation?

Similarly, profit maximisation offers us somewhere from which to base the rest of our analysis.

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