Profit Maximization of the firm

We now turn to the analysis of profit maximization. In this section, we ask whether firms do indeed seek to maximize profit. Then in Section 8.3, we will describe a rule that any firm—whether in a competitive market or not—can use to find its profit-maximizing output level. Finally, we will consider the special case of a firm in a competitive market. We distinguish the demand curve facing a competitive firm from the market demand curve, and use this information to describe the competitive firm’s profit-maximization rule.

1. Do Firms Maximize Profit?

The assumption of profit maximization is frequently used in microeconomics because it predicts business behavior reasonably accurately and avoids unnec- essary analytical complications. But the question of whether firms actually do seek to maximize profit has been controversial.

For smaller firms managed by their owners, profit is likely to dominate almost all decisions. In larger firms, however, managers who make day-to-day decisions usually have little contact with the owners (i.e., the stockholders). As a result, owners cannot monitor the managers’ behavior on a regular basis. Managers then have some leeway in how they run the firm and can deviate from profit-maximizing behavior.

Managers may be more concerned with such goals as revenue maximiza- tion, revenue growth, or the payment of dividends to satisfy shareholders. They might also be overly concerned with the firm’s short-run profit (perhaps to earn a promotion or a large bonus) at the expense of its longer-run profit, even though long-run profit maximization better serves the interests of the stockholders.1

Because technical and marketing information is costly to obtain, managers may sometimes operate using rules of thumb that require less-than-ideal informa- tion. On some occasions they may engage in acquisition and/or  growth strate- gies that are substantially more risky than the owners of the firm might wish.

The recent rise in the number of corporate bankruptcies, especially those in the financial sector, along with the rapid increase in CEO salaries, has raised questions about the motivations of managers of large corporations. These are important questions, which we will address in Chapter 17, when we discuss the incentives of managers and owners in detail. For now, it is important to realize that a manager ’s freedom to pursue goals other than long-run profit maximiza- tion is limited. If they do pursue such goals, shareholders or boards of directors can replace them, or the firm can be taken over by new management. In any case, firms that do not come close to maximizing profit are not likely to survive. Firms that do survive in competitive industries make long-run profit maximiza- tion one of their highest priorities.

Thus our working assumption of profit maximization is reasonable. Firms that have been in business for a long time are likely to care a lot about profit, whatever else their managers may appear to be doing. For example, a firm that subsidizes public television may seem public-spirited and altruistic. Yet this beneficence is likely to be in the long-run financial interest of the firm because it generates goodwill.

2. Alternative Forms of Organization

Now that we’ve underscored the fact that profit maximization is a fundamental assumption in most economic analyses of firm behavior, let’s pause to consider an important qualifier to this assumption: Some forms of organizations have objectives that are quite different from profit maximization. An important such organization is the cooperative—an association of businesses or people jointly owned and operated by members for mutual benefit. For example, several farms might decide to enter into a cooperative agreement by which they pool their resources in order to distribute and market milk to consumers. Because each par- ticipating member of the milk cooperative is an autonomous economic unit, each farm will act to maximize its own profits (rather than the profits of the coopera- tive as a whole), taking the common marketing and distribution agreement as given. Such cooperative agreements are common in agricultural markets.

In many towns or cities, one can join a food cooperative, the objective of which is to provide its members with food and other groceries at the lowest possible cost. Usually, a food cooperative looks like a store or small supermar- ket. Shopping is either restricted to members or else unrestricted with members receiving discounts. Prices are set so that the cooperative avoids losing money, but any profits are incidental and are returned to the members (usually in pro- portion to their purchases).

Housing cooperatives, or co-ops, are another example of this form of organi- zation. A co-op might be an apartment building for which the title to the land and the building is owned by a corporation. The member residents of the co-op own shares in the corporation, accompanied by a right to occupy a unit—an arrangement much like a long-term lease. The members of the co-op can partici- pate in the management of their building in a variety of ways: organizing social events, handling finances, or even deciding who their neighbors will be. As with other types of cooperatives, the objective is not to maximize profits, but rather to provide members with high-quality housing at the lowest possible cost.

A related type of organization, especially relevant for housing, is the condo- minium. A condominium (or “condo”) is a housing unit (an apartment, con- nected town house, or other form of real estate) that is individually owned, while use of and access to common facilities such as hallways, heating system, elevators, and exterior areas are controlled jointly by an association of condo owners. Those owners also share in the payment for the maintenance and oper- ation of those common facilities. Compared to a cooperative, the condominium has the important advantage of simplifying governance, as we discuss below in Example 8.1.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.