Profit Meximieation: An Outdated Hypothesis? ‘Alan 0’Keane Introduction Profit Haximieation must be one of the most elusive, ill-defined concepta in modern economics. It has, @ result, been both totally accepted and utterly rejected as the single goal of the firm by economists vorking at the same time and studying the same type of companies. In thie article I vill attempt to formulate a more realistic, relevant idea of profit maximisation. I will aiso discuss briefly the alternative enterprise objectives as postulated by Baumol, Narrie et al and explain vhy I eee these ‘alternative’ objectives ag rere vehicles for vhat must essentially be the long-term goal of the majority of entrepreneurs/administrators; that goal of the highest possible profite given the multitude of conatreinte vithin vhich all firme find thengelves I vill diecuee the reasona vhy thie ie so, and the implications of such aims and I will conclude vith reference to some empirical work in thie field. The Weo-Chi Theory The Neo-Classical theory of the firm hi following: as its basic essumptiona the 1) The entrepreneur im algo the ovner of the firm. 2) The firm hag a single goal; that of profit maximisation. 9) This goal is attained by the application of the narginaliat principle. 4) The vorld is one of certainty. 5) Entry assumptions vary according to the particular model. 6) The firm acts within a certain time horizon which depend2 on various factors such ag the rate of technological progress, the capital intensity of the methods of production etc. Yhen considered againat the background of the complex vorld of modern business many of these assumptions appear simplistic and antiquated. in particular, the agsumption of the vorld’as one of certainty and that of the attainment of profit maximisation through the conscious application oz the marginalist principle contradict most people’s knowledge and perception of the modern buginesa vorld. The goal of profit maximigation, according to the theory is attained by maximising profits in each period of the tine horizon of the firm, because the time periods are independent in the sense that decisions taken in any one period do not affect the benaviour of the firm in other periods. (#1) The notion that businessmen consciously apply the marginaliat principle ‘equating marginal cost with marginal revenue in price and output decisions) is vhere the theory firat falle foul of empirical work done in thie field. In 1939 Hell and Hitch, in the results of a study of 32 tirns, "1 A good discussion of this feature of the neo-classical theory is to be found in Koutsoyiannis, ‘Modern Microeconomic:me to the conclusion that firma did not use the marginalist rule. (+1) Instead, they argued, firms set their price on the Average Cost Principle (Price = AVC + AFC + profit margin). The reagons vhy thie is go, according to Hall and Hitch, are firatly that firma knov neither their Demand Curve nor their Marginal cost schedules, hence the application of the-marginalist rule is imposible due to the lack of relevant information. Secondly, firma believe that the ‘full-cost price’-is the ‘right’ price since it allove a fair profit and covers the costs of production when the plant is normally utiliged. On asking businessmen about their goals, profit maximisation vas rarely stated tobe their goal. Most firms reported that they eimed at 9 fair level of profit, and that they aleo had other goals, such as the building up of goodwill, being fair to competitors, etc. If this assessment is true At dispels any notion of profit maximigation as the'main-goal. Nachlup has argued, hovever, that just because firms do not consciously ana mathematically calculate MC/MR, it does not mean that they do not intuitively vork out the right price based on subjective assessments of HC/MR hich may be every bit as good as those explicitiy calculated. (#2) Gorden vould attack such subjectivity and argue that it reduces NC/KR to a tautology: any price could be said to be based on somebody's subjective ascesament. (#3) Machlup found, in contrast to Hall and Hitch, that average cost pricing vas not incompatible with marginaliem (1.e. P = AC can lead to the game solution as MC = MR). To equate ignorance of marginal concepts with inability to maximise protits ie not unlike suggesting that because one cannot read or write music that one could not know how to play it. It geems nighly likey that a street vise entrepreneur vith his ear to the market and considering hara to quentify factore auch as customers’ preterence tor stable prices, the importance of goodwill, good competitor reiatacns etc. might be just ag capable of maximising profite as an overcautious bean-counter vho looks only at HC/MR and short-run profitability. Conaiderable contusion existe in the terminology of profit maximisation. It is particularly unfortunate that the terms ‘goal’ or ‘objective’ ana ‘attain’ are used interchangeably. It is obvaously a lot easier to come up with alternative, nore plausible behavioural hypothesis 1 you are seeking to disprove the theory that firme attain profit maximisation than to disprove that the long term goal of the firm is to maximise profits. The only vay that a firm aight attain profit maximisation in the snort term is if it vere content and permitted to stay stationary vith the same market share, seme sales etc. each year. Modern business 16 however cnaracterised by dynamic markets. Furnas thenselves are dynamic. Fev entrepreneurs are content vith the statue quo. Most constantly seek to innovate, to diversify, to tackle sone nev challenge. The one vay to facilitate tnese ambitions to earn a higher and higher rate of return is to make as mucn profit 96 possible in ell aspects of the business taking into account all ‘1 oR. Lb. Hall and C. i. Hatch, ‘Price Theory and Business Benaviour’. Oxtord Economic Papers, 1939. +2 Ff. Machlup, ‘Marginal Analysia and Empirical f + American Economic Review, 1946, +3 R.A. Gordon, ‘Short Period Price Determination 1n Theory ana Practice’ - American Economic Review, 1947.the conatraints on short-term profits (fixed factors) and alao recognising the importance of good labour relations, goodvill and so on iz long-term profit maximisation ig to be achieved. Confusion exists to vhat constitutes profit maximising behaviour on the part of firma and their administrators, ‘In theory of course, there is no limit to how high profits can soar. It. might be argued that a true profit maximisation strategy vould involve the sabotaging of conpetitora reputations or factories; the etealing of inpute; corporate espionage; insider trading etc. Obviously these actions are not included in the normal perception of profit ximiging behaviour. When ve speak of profit maximisation we mean that businesenen seek to maximise profita within the framework of all the constraints under which they operate vhile seeking all the time to eliminate or mitigate the effects of these constraints in their quest for greater profite. The limite of capacity,, market share, and gales, ail constitute constraints on the company and ite ability to maximise profits in the short tert These are thinga vhich the entrepreneur/administrator vill be constantly trying to chenge.. The need to be constantly innovative, to maintain good- vill, good labour relations, good competitor relations are aleo constraints on short-term profitability which ensure greater long-run profits. Even ignorance of marginal concepte can be a conetraint, particularly on small businesses, and may affect the magnitude of profits. It this is the case, the businessman vill learn to use these concepts to his advantage, if the opportunity arises. To pick some arbitrary factor like the fact that no businessman vorks 24 hours a day, 7 days a week and to.suggest, ae it has been, that this conetitutee @ valid reason vhy profit maximieation cannot be the main aim of the modern business corporation is absurd. Similsarly, the argument that becauge bueinesemen:sre seen to be primarily motivated by the four Pe (prestige, power, pay, perks) that therefore they cannot be profit naximisers is unrealiatic. These benefits are recognised internationally the gine qua non of motivation and positive reinforcement. Businessmen are vell known for vhat T. Boone Pickens calla their “ballroom size egos'.(*1) Their need for the superfluous trappings of success is part of the framevork in vhich you must operate - part of your constraints. In any event, many such embellishsenta often exist to impress customers, equity investors, creditors, etc. and aa such they are the price a firm pays for a dependable, prosperous, stable appearance. Whatever way you view perks, statue symbole and so on, they are a necessary part of your contrainte. Within these congtrainte you aim for maximum efficiency, maximum profitebility, | You change what you can by diversifying, by marketing, by trimming bits off costs, by increases in productivity etc., all aimed at increasing profits. wnat you cannot change, you make the beat of. This then, is the-new idea of profit maximisation as the objective of the firm and it might be termed ‘realistic profit maximisation’ or ‘profit maximisation subject to constraints.’ It appears to follow the ideas of Machlup. (#2) Machlup gay that the firm had a single goal; the maximisation "1 T. Boone Pickens, ‘Boon 1987. ‘An Autobiography’, Hodder and Stoughton, F, Machlup, ‘Marginal Analysie and Empirical Research’ - American Economic Review, 1946.