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Theory of Profit Maximization

Dr Shalini Trivedi
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Main Propositions of the Model

• Firm is a unit that transforms valued inputs to
outputs given the state of Technology.
• Firm strives towards the goal of profit
maximization.
• Market conditions for firm to operate are given.
• While choosing alternatives firm chooses the
one which helps it to maximize profits.
• Primary concern is to analyze the changes in the
prices and quantities of input and output.
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Assumptions of the theory

• The firm has a single goal of profit
maximization
• The firm acts rationally to attain this goal
• The firm is a single ownership one.
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The Model
• Generation of profit over the time period being analyzed.
• Two time periods : Short run and long run
• There might be a conflict in profit maximization under two
terms might exist.
Examples are:
• Higher profits in the short run may in the long run induce
worker to demand high wages.
• Maximization of profit in the short run may give an impression
of a exploitative firm, this would affect long term profits.
• A firm trying to build up reputation might earn long term
profits.
• Firms can’t have independent periods.
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Determination of Profit Maximizing Output & Price

First Marginal Condition:

  TR  TC
 TR TC
Condtion1 :   0
X X X
TR TC
or : 
X X
MR  MC
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The second derivative of the production function is negative

  (TR )  (TC )
2 2 2

Condtion 2 :   0
X X X 2 2

 (TR )  (TC )
2 2

or : 
X X2 2

MR  MC
This Implies the slope of MR curve is less than the slope of MC curve.
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TC
Revenue and Cost K1
TR

K2

Q1 Q2 Q3
Profits

Q1 Q2 
Q3
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Critique of the NC Model

• Insufficiently realistic
• Based on oudated view of competition
1. Organizational goals
• Max. of profits or ???
2. Rationality ??
3. Perfect information ??
4. Decision making ??
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• The emphasis of the neoclassical theories is that

they miss dynamics
• The entrepreneur is the personification of the
firm, plays an unimportant role in the long run.
• Price competition is the only form of rivalry
• Schumpeter (1942) and the Austrian school give
the enterpreneur a central role within a more
dynamic model of competition
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Separaton of Ownership from Control

• Two implications:
– Increasing organizational complexity meant that it
was impossible for the large firms to be managed
solely by the owner
• Teams of managers
• Functional divisions
– Impractical for the enterpreneur to finance solely
by personal resources
• Presence of capital markets
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• Baumoul Sales Revenue Maximizing Model

• The oligopolistic firms aim at maximizing their sales revenue.
• Financial institution judge the health of a firm by the rate of
growth of sales revenue.
• There is a evidence that slack earnings of top management is
correlated with firms sales than its profits.
• Increase in Sales revenue provides over time provides prestige to
the top management, profit go to shareholders.
• Growing salaries keeps a healthy personnel policy.
• Managers prefer a steady performance with satisfactory profits.
• Large growing sales maintaining or increasing the share of a
firm increases competitive power.
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Baumol’s Sales Revenue Maximization

• Maximize sales revenue subject to
minimum profit constraint
• Why sales revenue and not profits??
– Sales are good general indicator of
organizational performance
– Executive power, influence, status tend to be
linked to the sales performance
– Lenders tend to rely on sales data
 Assumptions of the Model Name of Institution

• Goal of the firm is sales maximization subject

to minimum profit constraint.
• Advertisement is the major instrument of the
firm.
• Production cost are independent of advertising
• Advertising creates favorable condition for the
product
• Price of the product is assumed constant
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Sales Maximization Model

MR = 0
where
Q = 50

MR = MC
where
Q = 40
 Managerial Theories of the firm Name of Institution

• Ownership and control are divorced

• Managers have a primary role
• Maximize managerial Objectives
• Managerial utility is a combination of salary,
status, power, growth and job security.
• Managerial theories have been classified as :
– Sales revenue maximization model
– Managerial Utility Model
– Growth Maximization Model
 Willamson Model of Managerial
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Discretion

• Managers are free to pursue their own self interest

once they have achieved a level of profit that will pay
satisfactory dividends to shareholders and still ensure
growth.
• Self interest depends on many other things besides
salary
• Incase Goodwill of the firm serves their own ends
and ambitions the managers would be concerned else
would bypass it.
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• Market is not perfectly competitive

• Ownership and management are divorced
• Minimum profit constraint imposed on
managers by the capital market.
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• There are a set of factors that give rise to management

satisfaction.
• Managers at their own discretion pursue policies which
maximize their own utility rather than maximizing profit.
• Managerial Satisfaction depends on : prestige, status,
responsibility, dominance, professional excellence,
salary etc.
• Williamson introduces a concept of expense preference:
which is defined as satisfaction which managers derive
from certain type of expenses.
• Expenses are thereby pecuniary and non-pecuniary
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• Expense here is measured with the aid of three

variables
– A. Additional expenditure on staff
– B. Managerial Emoluments
– C. Discretionary Investment
• U= f(S,M,Id)
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• Managers take up projects that appeal to

him but which may not be in the best
interest of firm in terms of profit
generation.
• Profit deemed as scientific progress may
not be economically efficient.
 Growth Maximization Model
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• Rate of growth and potential of growth are yardsticks

to measure corporate success
• Growth can be financed from retained earnings or
from market borrowing or both
• Internal Financing is preferred to growth through
borrowed funds
• Internal funds grow only through profit
maximization.
• Decision to maximize growth is also the decision to
maximize profit.
 Marris Name of Institution

• Executive are limited by the need for management to

protect itself from dismissal or takeover in the event
of failure.
• Like Williamson he believes that management and
ownership are different.
• Um= f(salaries, power, status, job security)
• Uo= f( profits, market share, output, capital and
public esteem)
• These two variables are correlated with size of the
firm.
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• Variables that measure size are listed as : capital ,

output, revenue and market share.
• Marris defines them in terms of corporate capital.
• Corporate capital “ sum total of book value of assets,
inventory, and short term assets including cash
revenue.
• Managers and owners aim to maximize the rate of
growth of size rather than absolute size.
• Rate of growth has a positive effect on the prospects
of promotion of managers, and also keeps the
shareholders satisfied.
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• Rate of growth has two constraints:

– Sure limit in the rate of managerial expansion
– Voluntary slowing down process from the desire of job
security.
• Marris proposes concept of financial constraint (a), determines
the risk attitude of top management. risk loving prefers high a
and risk averting a lower a. a is the weighted average of the
three:
• Liquidity Ratio (a1) = Liquid Assets/Total Assets
• Leverage Ratio (a2) = Value of Debts/Total Assets
• Profit Retention Ratio (a3) = Retained Profits/Total Profits
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• Max g= gd=gc
• Where
– Max g: Maximum Balanced growth
– Gd=growth rate of demand of products
– GC= growth rate of capital supply