Profit and Objective of the firm

Profit: Basic concept

• Profit: Revenue – Cost
• Revenue: Sales volume × Unit price
• Cost: Accounting costs Vs. Economic cost
• Role of profit:
– Determines types of goods and services to be sold
– Determines demand for various factors of production

Theory of profit
• Dynamic equilibrium (friction) theory
• Monopoly theory
• Innovation theory
• Managerial efficiency theory

Dynamic equilibrium theory

• Normal profit: Rate of return that the firms in a particular industry earn over a long
period of time
• All the firms want to earn at least a normal profit
• A firm or firms in a industry may earn profit above or below normal profit
• Temporary dislocation of various sectors of economy is responsible
• In case of higher than normal profit – many firms are attracted that ultimately reduces
profit
• In case of lower than normal profit – many producers leave the industry that ultimately
enhance profit by reducing supply
• Little time is taken for this adjustment
• Firms earn higher or lower than normal profit in the interim period

Monopoly theory
• Sometimes above normal profit is possible due to sole or significance dominance in the
market
• Source of monopoly power
• Law
• Economies of scale
• Control of natural resource
• Patent right

Innovation theory
• Innovation: New idea about product, place, price and promotion
• above normal profit is possible due to unique and successful innovation
• Example
– Microsoft
– Nokia
– Square food
Managerial efficiency theory
• Managerial efficiency – enables firm to come up with better idea, reduce cost and
wastage and prepare better to cope with the changes in business environment
• Firms can earn above normal profit is due to exceptional managerial skill
• Most of the firms now a days invest a lot in training and development for improving
managerial skills of their managers

Objectives of the firm

• Profit maximization objective
• Share holders wealth maximization objective
• Efficiency objective
• Non profit objective
– Maximization of quantity and quality of output
– Utility Maximization of the Administrator
– Cash Flow Maximization
– Satisfaction Maximization of the Stake holders

Profit maximization objective

• Commonly set objective
• Three different decisions regarding this objective
– Increase revenue more than the cost
– By reducing some of the costs more than it increases other costs (holding revenue
remains same)
– By Increasing some revenue more than it decreases other revenue (holding costs remain
same)
– By reducing the costs more than the revenue
• Each three decision has different implications resource allocation decisions

Shareholders’ wealth maximization Objective

• Takes two major factors into consideration:
– risk
– discounting money value
• This goal states that firm should maximize present value of expected future return to the
owners (shareholders)
• Shareholders’ wealth is the product of market price per share and the number of
outstanding shares

Efficiency objective
• Efficiency = Output ⁄Input
• Three different approaches:
– Maximizing out for given input (cost)
– Minimizing cost at given level of out put
– Maximizing net benefit
• Appropriate for public services, utility etc
Non profit objectives
• Some times, depending on the circumstances, firm can set some objective without any
direct relationship with profit.
• Non profit objective
– Maximization of quantity and quality of output
– Utility Maximization of the Administrator
– Cash Flow Maximization

Common terminologies:
Need
• Need is basic sense of deprivation
Want
• Want is specific object that we desire for satisfying our need.Everyone feels the same
kinds of needs but wants of different people can be different.
Demand
• Demand is the willingness to buy something, which is backed by the ability to do so
Utility
• Utility is the benefit that people get out of something. In the other word, utility is the
Need satisfying ability of the products
– Physical/form utility
– Place utility
– Time utility
Production
• Production is creation of utility by using the resources. When car is produced
(manufacturing) some utility is created. When a TV serial (service) is made utility is
created.
Consumption
• Consumption is destruction of utility throughuse. This definition is more applicable for
physical goods. When we consume (receive) a service, we only use the utility, not
destroy it.