Question

do you think economists should alter the way they model firm behavior? In other words, do you think it’s accurate to model firm’s behavior with the assumption that firm’s primary objective is to maximize profit? Explain your answer

Answer 1

Answer: Profit Maximization: Meaning and Explanation:

In the neoclassical theory of the firm, the main objective of a business firm is profit maximization. The firm maximizes its profits when it satisfies the two rules:

- MC = MR and,

- 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.

Profit Maximization is based on below assumptions:

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1. The objective of the firm is to maximize 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 standardized 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 maximizes its profits over some time-horizon.

10. Profits are maximized both in the short run and the long run.

Given these assumptions, the profit maximizing model of firm can be shown under perfect com­petition and monopoly.

Profit Maximization for a Monopoly:

• 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.

In above Figure, the profit maximizing level of output is OQ and the profit-maximization price is OP. If more than OQ output is produced, MC will be higher than MR, 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.

Profit Maximization in Perfect Competition:

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 Figure 1 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 OM₁ it will be including losses, for the marginal cost exceeds the marginal revenue after the equilibrium point B. Thus the firm maximizes its profits at M₁ B price at the output level OM₁.

* However, it’s not accurate to model firm’s behavior with the assumption that firm’s primary objective is to maximize profit as there are certain limitations too which are mentioned below:

- Profits 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 maximize their profits under conditions of uncertainty.

- In the real world, it is not so easy to know exactly your marginal revenue and the marginal cost of last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their good – which determines the MR.

- It also depends on how other firms react. If they increase the price, and other firms follow, demand may be inelastic. But, if they are the only firm to increase the price, demand will be elastic.

-However, firms can make a best estimation. Many firms may have to seek profit maximization through trial and error. e.g. if they see increasing price leads to a smaller % fall in demand they will try increase price as much as they can before demand becomes elastic.

- It is difficult to isolate the effect of changing the price on demand. Demand may change due to many other factors apart from price.

- Firms may also have other objectives and considerations. For example, increasing price to maximize profits in the short run could encourage more firms to enter the market; therefore firms may decide to make less than maximum profits and pursue a higher market share.

- Firms may also have other social objectives such as running the firm like a cooperative – to maximize the welfare of stakeholders (consumers, workers, suppliers) and not just profit of owners.

- Profit Satisficing. This occurs when there is separation of ownership and control and where managers do enough to keep owners happy but then maximize other objectives such as enjoying work.

Conclusion : Therefore, it can be concluded with help of above points by saying that, it’s not accurate to model firm’s behavior with the assumption that firm’s primary objective is to maximize profit.

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