In the conventional theory of the firm, the principle objective of a business firm is to maximize profit. Under the assumptions of given taste and technology, price and output of a given product under competition are determined with the sole objective of maximization of profit.
Profit maximization refers to the maximization of dollar income of the firm. Under profit maximization objective, business firms attempt to adopt those investment projects, which yields larger profits, and drop all other unprofitable activities. In maximizing profits, input-output relationship is crucial, either input is minimized to achieve a given amount of profit or the output is maximized with a given amount of input. Thus, this objective of the firm enhances productivity and improves the efficiency of the firm.
The conventional theory of the firm defends profit maximization objective on the following grounds:
- In a competitive market only those firms survive which are able to make profit. Hence, they always try to make it as large as possible. All other objectives are subjected to this primary objective.
- Profit maximization objective is a time-honored objective of a firm and evidence against this objective is not conclusive or unambiguous.
- Though not perfect, profit is the most efficient and reliable measure of the efficiency of a firm.
- Under the condition of competitive market, profit can be used as a performance evaluation criterion, and profit maximization leads to efficient allocation of resources.
- Profit maximization objective has been found extremely accurate in predicting certain aspect of firm’s behavior and trends; as such the behavior of most firms are directed towards the objective of profit maximization.
Criticisms or Drawbacks of Profit Maximization Objective
Although profit maximization objective is widely known objective of a firm, some theorists have raised doubts on the validity of this objective. They have criticized the profit maximization objective on the following grounds:
- The profit maximization objective ignores the timing of returns. It equates a dollar received today with a dollar received in the future. In fact, $ 100 today is valued more than $ 100 received after one year. It is because the money received in earlier period may be reinvestable to earn more.
- The critics of profit maximization objective argue that it ignores the risk associated with stream of cash flow of the project. For example, the total profit from two projects may be same but the profit from one project may be fluctuating widely than the profit from the other project. The firm with wider fluctuation in profit is riskier. This fact is ignored by profit maximization objective.
- The profit maximization objective has greater relevance to a perfectly competitive firm than to a monopoly firm. Critics argue that a monopoly firm would be earning super normal profit more or less automatically.
- Today large-scale corporate type of organizations exist. Different stakeholders such as owners, managers, customers, creditors, and employees are directly connected with the organization. The interest of each member in this organizational collusion cannot be achieved with the sole objective of profit maximization.
- The profit maximization objective of the firm has greater relevance to short-run. In long-run, a firm cannot survive with this objective.
- If all firms keep profit maximization as the primary objective, they may commit unfair practice to maximize profit.