Profit maximization is the most important assumption, which helps the economists to introduce the price and production theories. The traditional economic theory assumes that the profit maximization is the only objective of business firms. According to this theory, profits must be earned by business to provide for its own survival, coverage of risks, growth and expansion. It is a necessary motivating force and it is in terms of profits that the efficiency of a business is measured. It forms the basis of conventional price theory. Profit maximization is regarded as the most reasonable and analytically the most productive business objective.
The profit maximization assumption in this theory helps in predicting the behavior of business firms and also the behavior of price and out pet under different market conditions. No alternative hypothesis or assumption explains and predicts the behavior of firms better than the profit maximization assumption.
The traditional theory supports the profit maximization hypothesis also on the following grounds:
- Profit is essential for survival of a business: The survival of all the profit oriented firms in the long run depends on their ability to make a reasonable profit depending on the business conditions and the level of competitor. Profit is the biggest incentive for work. It is the driving force behind the business enterprise. It encourages a man to work to do the best of his ability and capacity. Making a profit is a necessary condition for the survival of the firm. Once the firms are able to make profit, they try to maximize it.
- Achieving other objectives depends on the ability of a business to make profit: Many other objectives of business are maximization of managerial utility function, maximization of long-run growth, maximization of sales revenue. The achievement of such alternative objectives depends wholly or partly on the primary objective of making profit.
- Profit maximization objective has a greater predicting power: As compared to other business objectives, profit maximization assumption has been found to be good in predicting certain aspects related to a business. Milton Friedman supports this by saying that the profit maximization is considered to be good only if it predicts the business behavior and the business trends correctly.
- Profit is a more reliable measure of efficiency of a business: Thought not perfect, profit is the most efficient and reliable measure of the efficiency of a firm. It is also the source of internal finance. The recent trend shows a growing dependence on the internal finance in the industrially advanced countries. In fact, in developed countries, internal sources of finance contribute more than three-fourths of total finance. Keeping this in mind, it can be said that profit maximization is a more valid business objective.
In practice, however, firms have been found to be pursuing objectives other than profit maximization. For the large business firms, pursuing goals other than profit maximization is the distinction between the ownership and management. The separation of management from the ownership gives managers an opportunity to set goals for the firms other than profit maximization. Large firms pursue goals such as sales revenue maximization, maximization of managerial utility function, maximization of firm’s growth rate, making a target profit, retaining market share, building up the net worth of the firm, etc. Secondly, traditional theory assumes perfect knowledge about current market conditions and the future developments in the business environment of the firm. Thus a business firm is fully aware of its demand and cost functions in both short and long runs. The market conditions are assumed to be certain. On the contrary, it is also recognized that the firms do not possess the perfect knowledge of their costs, revenue, and their environment. They operate in the world of uncertainty. Most of the price and output decisions are based on probabilities.