Business economics: fundamentals and applications

Business Economics

Profit Maximization Theory

The primary purpose of any company consists in obtaining profit. Once a company is productive and successful, it will focus on maximizing its profit. Therefore, profit maximization is the objective that the company's managers and their subordinates have to attain.

Within the community the company is active in, the necessary goods must be obtained through certain activities, which therefore lead to the problem regarding their cost. In nowadays global economy, producers use limited economic resources in order to produce goods by maximizing profits. The decision to produce economic goods, in terms of relatively limited resources, with alternative usage, engages two categories of efforts:

The first is determined by production factors involved in the economic activity

The second one is related to factors that must be left aside as a consequence of restrictions that come with the possibilities involved

The resources necessary for producing certain material goods and services together with the losses that emerge in case of passing the opportunity to produce other goods constitute the producer's cost. This cost consists in the production cost and the opportunity cost. The production cost is consisted of all the economic resources engaged in producing the goods. The opportunity cost represents the cost of the lost production alternative, and it is considered to be a relative cost.

Economic theories regarding cost have evolved during decades. For example, Adam Smith identifies the cost with the real price of the good. In his opinion, the real price of any good, the cost that the buyer literally pays, is the equivalent of the concern required for purchasing it. In other words, this price is consisted of the rent, wage, and profit that must be paid in order for the good to enter the market. Karl Marx considers the cost to be part of the good's value, the price that the producer must pay in order to produce the good, measured by constant and variable expenses. J.B. Say considers that cost is a reward for services and production factors, combined, substituted, and used in the production activity. The opportunity cost term was introduced in the economic literature by Karl von Wieser, as the profit expected from a production good, with alternative usage.

Given the relationship between the evolution of certain expenses and production modification, the production cost is consisted of variable cost and fixed cost. The variable cost category includes those production expenses that change in the same direction as production does, on a short period of time. The variable cost includes: raw material expenses, energy expenses, salaries expenses, and others. The fixed cost category includes those production expenses that do not depend on the volume of production on short-term, they remain relatively unchanged. The total production cost is consisted of the variable cost and the fixed cost.

Given the nature of expenses, there are two cost categories: explicit cost and implicit cost. The explicit cost includes all the expenses made by the producer for purchasing the production factors: raw materials, materials, energy, fuel, and workforce. The implicit cost is represented by the opportunity cost. The implicit cost is only important for determining the profit, as a difference between the total income and the total production cost.

The profit maximization process can be approached in two distinct manners, by following either the total revenue - total cost method, or the marginal revenue - marginal cost method. The relationship between the average cost and the marginal cost can be analyzed by taking into consideration the producer's decision regarding the volume of production on short-term and on long-term, in order to maximize the company's profit.

The producer's decision to increase the volume of production on short-term, as a consequence of signals sent by the market under discussion, can only be accomplished by combining fixed production factors with variable production factors. This will lead to increased profits, but only for a short period of time, as this process cannot be sustained for a longer period of time. Therefore, given the fact that the increase in the production's volume takes place by combining fixed production factors with variable production factors, the marginal cost represents the main criterion for the fundamental base of the decision to produce. On short-term, the combination of production factors in the manner mentioned above, is under the influence of decreasing marginal productivity law's action.

Taking into consideration the fact that the marginal cost is determined by the cost increase of variable factors, it means that when the marginal production increases, the marginal cost is reduced. When marginal production is reduced, the marginal cost increases. At a maximum marginal production level the marginal cost is at its lowest. At this minimum level of the marginal cost, marginal income is at its highest.

However, the situation slightly changes on long-term. All production factors are variable. In these circumstances, the company has the opportunity to increase production by modifying the volume of all production factors, which will lead to a reduction of the total average cost.

In other words, the marginal cost is not affected by the law of marginal decreasing productivity on long-term. As a consequence of decreasing the total average cost, together with increasing the volume of production, the income that exceeds the production cost increases. This profit is obtained by increasing production, based on increasing the production capacity. The modification of all production factors has certain effects on the volume of production, generating a relationship between the increase in the volume of production and the reduction of the total average cost.

In other words, there is a relationship between the modification of the production volume and the total average cost modification. This relationship can be either positive, or negative. Given the fact that by expanding production as a consequence of the modification occurred in all production factors, average costs are reduced, and the exceeding profit is actually consisted in savings by obtaining increased production at lower costs.

The profit maximization theory has evolved a great deal over the past decades, being subjected to several changes by economy theorists. These changes were due to changes that occurred in the global economy. Given these practical changes, theory had to adapt to them.

For example, in the 1930s, the marginalism debate was introduced by the Oxford Research Group in 1939, on the one hand, and by R.A. Lester in 1946, on the other hand (HET, 2008). The debate stated that "empirically, it was not apparent that entrepreneurs followed the marginalist principles of profit maximization/cost minimization in running their firms. In particular, they found that many firms conducting full cost pricing rules and routines and that predicted falls in unemployment as a result of higher wages were not evident" (HET, 2008). Even more, adepts of the old marginalism debate considered that the relevance of the profit maximization assumption was not as important as most economy theorists and considered.

However, other theorists found certain arguments that were designed to counteract the opinions mentioned above. They considered that the reason for which profit maximization was hard to notice in most companies was due to the fact that the information required for such calculations, marginal revenue and costs, were quite difficult to obtain.

Other theorists were even more fervent in defending the old marginalist approach. Fritz Machlup and George Stigler considered that "even if they did not have their roots in conscious decisions, one must be careful about the meaning of marginalist analysis. There are many factors that may affect profits and thus, as many traditional relations implied by profit maximization are often considered in theoretical isolation, they are rarely isolated in fact" (HET, 2008). These traditional relations implied by profit maximization refer to rises in wages leading to less employment.

However, these debates on the old marginalism theory changed significantly in the 1970s due to the emergence of the theories of agency costs, property rights, transactions costs theories of the firm. The new institutionalist theories were going hand in hand with Friedman's theory regarding the objective of the company. Those in favor of the theory considered that companies that followed a profit maximization direction were considered to be efficient and successful and would be selected for, while companies that were not following a clear and intentional profit maximization oriented direction were considered to be inefficient and would be selected against.

The theory returned to its roots in 1980s, when the old marginalist debate re-emerged. Richard Nelson and Sidney Winter were responsible for this, by, in 1982, combining the earlier Alchian-Becker arguments with the new institutionalists' theories of the firm. Afterwards, profit maximization theory was linked to utility theory and decision theory (Haring & Smith, 1959).