BBA I Semester Managerial Economics Profit Maximisation Study Material Notes
Table of Contents
BBA I Semester Managerial Economics Profit Maximisation Study Material Notes: Introduction profit maximization Theory Profi maximization Under Perfect Competition firm Profi maximization Under monopoly firm Criticism of he profit maximization Theory Exercise :
CCC NIELIT Questions Paper Practice Test Paper 2
PROFIT MAXIMISATION
INTRODUCTION
Every firm in managerial economics is a single unit whose entire operations are carried out by an entrepreneur. His main function is to bring together various factors of production, coordinate, supervise and manage them in order to produce goods and services for the firm so as to maximise profit. This is the principal objective of the firm in perfect competition, monopoly, monopolistic competition and oligopoly markets. This is known as the traditional or new classical theory of the firm.
But the profit maximization model of the firm is not based on the real behavior of the firm. In 1932. Berle and Means in their study of business firms in America came to the conclusion that the operations of modern firms are so complex that they cannot think about profit maximization. Their main problems are related to control and management. Their management is carried out not by entrepreneurs but by managers and shareholders. They take more interest in their salary and dividend. Since ownership and control in modern firms is in the hands of different persons, it is unrealistic to accept that the sole objective of modern firms is profit maximization. Therefore, economists have propounded a number of theories of the firm based on sales maximization, output maximization, utility maximization, satisfaction maximization and growth maximization.
Profit Maximization Material Notes
PROFIT MAXIMISATION THEORY
In the neo-classical theory of the firm, the main objective of a business firm is profit maximisation. The firm maximises its profits when it satisfies the two rules: (i) MC = MR and,
(ii) MC curve cuts the MR curve from below. Maximum profits refer to pure profits which are a surplus above the average cost of production. It is the amount left with the entrepreneur after he has made payments to all factors of production, including his wages of management. In other words, it is a residual income over and above his normal profits. The profit maximization condition of the firm can be expressed as:
Maximise (2)
Where (Q)= R(Q)-C(Q) where (Q) is profit, R(Q) is revenue, C (Q) are costs, and are the units of output sold.
The two marginal rules and the profit maximization condition stated above are applicable both to a perfectly competitive firm and to a monopoly firm.
Assumptions
The profit maximisation theory is based on the following assumptions:
1 The objective of the firm is to maximise its profits where profits are the difference between the firm’s revenue and costs.
2. The entrepreneur is the sole owner of the firm.
3. Tastes and habits of consumers are given and constant.
4. Techniques of production are given.
5. The firm produces a single, perfectly divisible and standardised commodity.
6. The firm has complete knowledge about the amount of output which can be sold at each price.
7. The firm’s own demand and costs are known with certainty.
8. New firms can enter the industry only in the long run. Entry of firms in the short run is not possible.
9. The firm maximises its profits over some time-horizon.
10. Profits are maximised both in the short run and the long run.
Given these assumptions, the profit maximising model of firm can be shown under perfect competition and monopoly.
Profit Maximisation under Perfect Competition Firm
Under perfect competition, the firm is one among a large number of producers. It cannot influence the market price of the product. It is the price-taker and quantity-adjuster. It can only decide about the output to be sold at the market price. Therefore, under conditions of perfect competition, the MR curve of a firm coincides with its AR curve. The MR curve is horizontal to the X-axis because the price is set by the market and the firm sells its output at that price. The firm is thus in equilibrium when MC = MR= AR (Price). The equilibrium of the profit maximization firm under perfect competition is shown in
where the MC curve cuts the MR curve first at point A. It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point A, the MC curve is below the MR curve. It does not pay the firm to produce the minimum, output when it can earn larger profits by producing beyond OM. It will, however, stop further production when it reaches the OM, level of output where the firm satisfies both conditions of equilibrium. If it has any plans to produce more than OM, it will be incurring losses, for the marginal cost exceeds the marginal revenue after the equilibrium point B. Thus the firm maximises its profits at M, B price at the output level OM
Profit Maximisation under Monopoly Firm
There being one seller of the product under monopoly, the monopoly firm is the industry itself. Therefore, the demand curve for its product is downward sloping to the right, given the tastes and incomes of its customers. It is a price-maker which can set the price to its maximum advantage. But it does not mean that the firm can set both price and output. It can do either of the two things. If the firm selects its output level, its price is determined by the market demand for its product. Or, if it sets the price for its product, its output is determined by what the consumers will take at that price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits. The conditions for equilibrium of the monopoly firm are.
(1) MC = MR<AR (Price),and
(2) the MC curve cuts the MR curve from below. the profit maximising level of output is og and the profit-maximisation price is OP. If more than OQ output is produced, MC will be higher than and the level of profit will fall. If cost and demand conditions remain the same, the firm has no incentive to change its price and output. The firm is said to be in equilibrium. Criticisms of the Profit Maximisation Theory
The profit maximization theory has been severely
Profit Maximization Material Notes
criticized by economists on the following grounds:
1 Profit Uncertain. The principle of profit maximization assumes that firms are certain about the levels of their maximum profits. But profits are most uncertain for they accrue from the difference between the receipt of revenues and incurring of costs in the future. It is, therefore, not possible for firms to maximise their profits under conditions of uncertainty.
2. No Relevance to Internal Organisation. This objective of the firm bears little or no direct relevance to the internal organisation of firms. For instance, some managers incur expenditures in excess of those that would maximise wealth or profits of the firm. Thry emphasize growth of total assets of the firm and its sales as objectives of managerial actions.
3. No Perfect Knowledge. The profit maximisation hypothesis is based on the assumption that all firms have perfect knowledge not only about their own costs and revenues but also of other firms. But, in reality, firms do not possess sufficient and accurate knowledge about the conditions under which they operate. At the most, they may have a knowledge about their own costs of production, but they can never be definite about the other firms.
4. Empirical Evidence Vague. The empirical evidence on profit maximisation is vague. Most firms do not rank profits as the major goal. The working of modern firms is so complex that they do not think merely about profit maximisation. Their main problems are of control and management. The function of managing these firms is performed by managers and shareholders and not by the entrepreneurs. They are more interested in their emoluments and dividends. Since there is substantial separation of ownership from control, firms are not operated to maximise profits.
5. Firms do not bother about MC and MR. The real world firms do not bother about the calculation of marginal revenue and marginal cost. Most of them are not even aware of the two terms. Others do not know about the demand and marginal revenue curves and their cost structure. Empirical evidence by Hall and Hitch shows that businessmen have not heard of marginal cost and marginal revenue.
6. Principle of Average-Cost Maximising Profits. Hall and Hitch found that firms do not apply the rule of equality of MC and MR to maximise short run profits. Rather, they aim at the maximisation of profits in the long run. For this, they do not apply the marginalistic rule but they fix their prices on the average cost principle. According to this principle, price equals AVC+AFC + profit margin (usually 10%). Thus the main aim of the profit maximising! firm is to set a price on the average cost principle and sell its output at that price.
7. Static Theory. The neo-classical theory of the firm is static in nature. The theory does not tell the duration of either the short period or the long period. It relates to identical and independent time periods. This is a serious weakness of the profit maximization theory.
8. Vague about Profits. The theory fails to explain which profits are to be maximized. Should a firm maximise its shoot-run or long-run profits? It is also not clear about the definition of profits. Should the firm maximise the amount of profits or the rate of profit? Profits in relation to total capital or in relation to owners’ equity in the firm are to be maximised. Should accounting profits or on cash flow be maximized?
9. Not Applicable to Modern Corporations. There is the separation of ownership and management in modern corporations. Modern corporations are motivated by different objectives because of the separate roles of shareholders who are owners and managers. In 1932, Berle and Means suggested that managers have different goals from shareholders. They are not interested in profit maximization. They manage firms in their own interests rather than in the interests of shareholders. Shareholders cannot have much influence on managers because they do not possess adequate information about companies. Thus besides profit, modern firms are motivated by objectives relating to sales maximization, output maximization, utility maximization, satisfaction maximization and growth maximization.
10. Inequalities. Profit maximization also leads to inequalities of income and wealth. Firms expand by earning large profits. Owners and managers become rich by fixing large salaries and bonus. On the other hand, workers are paid low wages and salaries.
11 Vague Concept. The concept of profit is not clear but is vague. Firms do not clarify whether the profit is short-term or long-term? Whether it is before or after tax profit? Whether it is operating profit or share holders’ profit?
EXERCISES
1 Discuss critically the profit maximization theory of the firm.
2. Explain the profit maximization theory. Why is it not applicable to modern firms?
