Profit Maximization

Profit maximization is the objective of a firm to maximise the difference between its total revenue and its total cost. Profit maximization is the standard assumption about the behaviour of firms in microeconomics, and it provides the basis for the analysis of supply and of market equilibrium.

The Condition

The condition for profit maximization is that the firm produces the quantity at which marginal revenue equals marginal cost. At this quantity, the additional revenue from producing one more unit equals the additional cost, so that the firm cannot increase its profit by changing its output.

For a competitive firm, which takes the market price as given, the condition becomes price equals marginal cost. The firm supplies output up to the point at which the marginal cost equals the price.

For a firm with market power, the marginal revenue is less than the price, since the firm must lower the price to sell more. The condition becomes marginal revenue equals marginal cost, and the resulting price exceeds the marginal cost.

Short Run and Long Run

In the short run, the firm decides whether to produce and how much, given the fixed inputs. The firm will produce if the price covers the average variable cost, and it will produce the quantity at which marginal revenue equals marginal cost.

In the long run, the firm can adjust all inputs and can enter or exit the industry. In a competitive industry, the long-run equilibrium is characterised by zero economic profit, since entry continues until the profit is eliminated.

The distinction between short-run and long-run profit maximization explains the difference between the short-run and the long-run supply curves, and the dynamics of entry and exit in an industry.

Criticisms

The assumption of profit maximization has been criticised on several grounds. Firms may pursue other objectives, including the maximisation of sales, of market share, or of the utility of the managers.

The separation of ownership and control means that the managers, who make the decisions, may have objectives that differ from those of the owners. The analysis of the firm must therefore consider the incentives of the managers and the mechanisms of corporate governance.

The assumption may also be a reasonable approximation, since firms that do not maximise profit tend to be eliminated by competition over time. The analysis of the firm must therefore balance the realism of the assumptions against their analytical convenience.

Applications

The condition for profit maximization is used in the analysis of pricing, of output, and of market structure. It is used in the analysis of the effects of taxes and of regulation, and in the analysis of the behaviour of firms in different market structures.

The condition is also used in the analysis of the effects of competition, since the difference between price and marginal cost is a measure of the market power of the firm. The analysis of the markup and of its determinants is central to the analysis of market structure.

Alternative Objectives

The assumption of the profit maximization has been supplemented by the analysis of the alternative objectives of the firm. The alternatives include the maximisation of the sales, of the growth, and of the utility of the managers.

The analysis of the behaviour of the firm under the separation of the ownership and the control has been developed by the economists including William Baumol and Oliver Williamson. The analysis holds that the managers pursue their own objectives, which may include the size of the firm and the perquisites.

The analysis of the objectives informs the understanding of the behaviour of the firm and of the design of the corporate governance. The mechanisms of the governance, including the board of the directors and the structure of the compensation, affect the alignment of the interests.

The Dynamics of the Competition

The analysis of the profit maximization is central to the analysis of the competition and of the market structure. In the competitive markets, the firms that do not maximise the profit are eliminated by the competition over time.

The dynamics of the competition mean that the profit maximization may be the long-run outcome, even when the firms pursue the other objectives in the short run. The analysis of the dynamics informs the understanding of the equilibrium of the market.

The analysis also considers the role of the entry and of the exit. The entry of the new firms drives the profit to zero, and the exit of the firms that cannot cover the cost restores the profit for the remaining firms.

The Measurement of the Profit

The measurement of the profit is complicated by the differences between the accounting profit and the economic profit. The accounting profit is the revenue minus the explicit costs, while the economic profit also deducts the opportunity cost of the resources.

The distinction matters for the analysis of the behaviour of the firm, since the firm may report a profit while earning less than the opportunity cost of the capital. The distinction also matters for the analysis of the market, since the economic profit determines the entry and the exit.

The measurement of the profit is also affected by the treatment of the depreciation, of the inventory, and of the other items. The accounting standards determine the measurement, and the differences across the jurisdictions complicate the comparison.

Summary

Profit maximization is the standard assumption about the behaviour of the firm, and it provides the basis for the analysis of the supply and of the market equilibrium. The analysis of the alternative objectives, of the dynamics of the competition, and of the measurement of the profit informs the understanding of the firm.

See also

• Microeconomics
• Cost Function
• Market Structure