On Maximizing Profits - Essay Example

On Maximising Profits In much of economic theory, it is assumed that a business aims to maximise profits. In reality, most businesses which are runfor "commercial gain" do have profit maximisation as an important objective - since the shareholders have taken a risk investing in the business and demand a return (profit) to compensate them for their risk. There are, however, many other potential financial objectives that a business can assume (Objectives to Business - Alternatives to Profit Maximisation 2005). According to Enke (1965, p.53), it is quite unreasonable to suppose that each firm acts to maximise profits on grounds that in face of uncertainty, the profit maximising motive does not provide the entrepreneur with a single and clear criterion for selecting one policy from among the set of alternatives open to him. The desire to maximise profits does not form a clear and unique behaviour prescription. Enke (1965, p.54) adds that consequently, the economist cannot make individual-firm predictions in the short run.1 When the future outcomes of present decisions are uncertain, motivation does not constitute a criterion for each entrepreneur. To clarify motivation and criterion, Enke (1965, p.53) provides the following extreme gambling example. Suppose that one gambler might be given a hundred dollars and is told to make a single bet at a roulette table and "maximise profits" whereas another player might similarly be given one hundred dollars but then to "maximise losses." If they are obedient, both gamblers will play a number than a colour because, if they are ever to secure the maximum profits and maximum losses that they respectively seek, the longest odds provide profits or losses at the highest rate; if they both played a colour, they would be acting that is inconsistent with their instructions. Unless people have beliefs concerning the likelihood of certain future events occurring, a specific motivation cannot provide them with criterion for selecting one alternative from one another. The economist cannot predict how an entrepreneur will act if the economist does not know the entrepreneur's assessments of future probabilities (Enke 1965, p.55). Baumol (1961, p.193) also provides an example as to why the profit-maximising assumption does not hold for all firms. A small firm that is run by its owner may seek to maximise the proprietor's free time subject to the constraint that his earnings exceed some minimum level, and, indeed, there have been cases of overworked businessmen who, on medical advice, have turned down profitable business ventures. According to Anthony (1965, p.61), if a firm is to maximise its profits, the businessman must set a price such that the marginal revenue equals the marginal cost. This means that as a minimum he must be able top estimate the demand at all prices and the marginal cost at all volumes, and he must further estimate the extent to which demand is interdependent with cost because of advertising and other order-getting expenditures. In practice, states Anthony, is a "fantastically" [emphasis mine] difficult task, so difficult that is rarely attempted in practice. In Anthony's words: "who can accurately estimate the demand for a product at even one price" Another critic of the profit maximising firm is the "denigration" of the importance of managerial activity or to imply that it is without significant difficulties. Baumol (1993, p.3) defines the manager as the individual who oversees the ongoing efficiency of the continuing processes. In its generic and simplest form, the theoretical firm must choose among alternative values for a small number of rather well-defined variables: price, output, perhaps advertising outlay, and occasionally, a few others. The firm is then to perform a mathematical calculation which yields the optimal (profit maximising) values for all of its decision variables that the theory declares the firm's vector of decisions. Until there is such a shift in one of the relationships that define the problem, the firm is taken to replicate precisely its previous decisions, day after day, year after year. Clearly, the entrepreneur has been read out of the model. The management group becomes a passive calculator that reacts mechanically to changes imposed by fortuitous external developments over which it does not exert Baumol (1993, p.12-13). Profits or Sales: Which to Maximise Broer (1987, p.14) discusses that the neoclassical theories of the firm seek to explain the behaviour of the firm by a profit maximising objective, where the environment acts as a constraint. In the earlier stages of the theoretical development, attention was limited mainly to an analysis of the conditions of static equilibrium, notably in the case of perfect competition. Because of this limitation the effects of changes in economic conditions on the behaviour of economic agents could only be studied through comparative statics, while the adjustment patterns and time remained largely beyond the scope of the analysis. A potential financial objective that a business can assume other than the neo-classical profit maximising model is the sales maximisation model developed by William J. Baumol. According to Baumol (1961, p.193), on the basis of some observation, firms often seek to maximise the money value of their sales (their total revenue) subject to a constraint that their profits do not fall short of some minimum level which is just on the border of acceptability. That is, so long as profits are at a satisfactory level, management will devote the bulk of its energy and resources to the expansion of sales. In general, the model argues that businesses will try to maximise sales or revenues rather than profits. Baumol (1967, p.45) argues that there are many reasons why a businessman opts to show more concern about his sales magnitude rather than on the magnitude of his profits. Declining sales can bring with them all sorts of disadvantages: there is a reason to fear that consumers will shun a project if they feel it is falling in popularity, though information on these matters is certainly often unclear. Banks and the money market will also tend to be less receptive to the desires of a firm whose absolute or relative sales volume is declining. Perhaps even more important is the very real danger that firms whose sales are falling will lose distributors. Other possible motives for such an objective may include: (1) grow or sustain market share, (2) ensure survival, (3) discourage competitors (particularly new entrants to a market), (4) build the prestige of the senior management - who like to be seen running a large rather than a particularly profitable business, or (5) achieve bonuses - if these are based on revenues rather than profits (Objectives to Business - Alternatives to Profit Maximisation 2005). Price-determining mechanisms between profit maximisation and sales maximisation models also differ in nature. Broer (1987, p.15) cites the lack of a price-determining mechanism in the neoclassical analysis in terms of the actions of economic agents2. Prices are assumed to adjust instantaneously to clear all markets, but, because this adjustment is not the consequence of the deliberate action of any agent, price determination was not 'explained' within the neoclassical framework. Using the rule of thumb for the profit-maximising model, Baumol (1961, p.196) states that we need merely determine how a change on the firm's output and pricing shifts the marginal cost (MC) curve to find the new profit-maximising price-output combination by finding the new point of intersection of the MC and marginal revenue curves. However, using the fact derived from the profit maximising model that a change in fixed costs never has an effect on the firm's marginal cost curve3, Baumol (1961, p.196) argues that if for instance, the profit-maximising firm's rents increase, there will be no change in the output-price level at which its marginal cost equals its marginal revenue. Baumol narrates: In other words, the profit-maximising firm will make no price or output changes in response to any increase or decrease in common fixed costs! This rather unexpected result is certainly not in accord with common business practice On the other hand, if the profit-maximising rule is "marginal cost equals marginal revenue", sales maximization will be obtained at a well-determined output level where the well-known rule that elasticity of demand is unity, i.e., where marginal revenue (MR) is zero holds (Baumol 1967, p.198). This condition then replaces the MR=MC profit-maximising rule. Baumol also notes that sales maximisation under a profit constraint does not mean to attempt to obtain the largest possible physical volume, but also cautioned that maximum sales might also require prices so low that the costs would never be covered. If at the revenue-maximising output, the firm earns enough or more than enough profits to meet the competitive requirements, then it will want to produce at that sales-maximising level. But if at this output profits are too low (or below the minimum profit level), the firm's output must be changed to a level which, though it fails to maximise sales, does not meet the profit requirement. In sum, two types of equilibrium can happen in the sales maximisation model: one in which the profit constraint (minimum profit level) does not provide an effective barrier to sales maximisation, and one in which it does (Baumol 1967, p.199). Conversely, Baumol also cites that it is not generally true that an any output level for a profit-maximising firm where MR=MC will be the "optimal" level. There may be several levels of production at which marginal cost and marginal revenue are equal (e.g. a concave upwards MC intersected by a linearly downward sloping MR at two different points), and some of these output quantities may be far from advantageous for a firm (1967, p.195). Baumol also found out the following converging results between the sales-maximising firm and the profit-maximising firm on the choice of input and output combinations: given the level of expenditure, both types of firms will produce the same quantity of each output and will market it at the same ways. Similarly, given the level of their total revenues, the two types of firms will optimally use the same inputs in identical quantities and will allocate them at the same way (Baumol 1967, p.201). Why is this so Baumol points out that given the level of costs, since profit equals revenue minus costs, whatever maximises profits must maximise revenues. Hence, differences between the profit and the sales maximiser's output composition or resource allocation must be attributed not to a reallocation of a given level of costs (or revenues) but to the larger outputs (and hence total costs and revenues), which, are to be expected to accompany sales maximisation (Baumol 1967, p.202). Reference List Anthony, R 1965, 'The Trouble with Profit Maximization', in Markham J (ed), Price Theory in Action, Donald Stevenson Watson, United States of America, pp.58-66. Baumol, W 1967, Business Behavior, Value and Growth, Harcourt, Brace & World, Inc., United States of America. Baumol, W 1961, Economic Theory and Operations Analysis, Prentice-Hall, Inc., United States of America. Baumol, W 1993, Entrepreneurship, Management, and the Structure of Payoffs, Massachusetts Institute of Technology., United States of America. Broer, B 1987, Neoclassical Theory and Empirical Models of Aggregate Firm Behaviour, Martinus Nijhoff Publishers, Dordrecht. Enke, S 1965, 'On Maximizing Profits', in Markham J (ed), Price Theory in Action, Donald Stevenson Watson, United States of America, pp.53-57. Objectives to Business - Alternatives to Profit Maximisation 2005. Retrieved February 10, 2006, from Http:// www.tutor2u.net/business/accounts/business_objectives_alternativeshtm. Read More