Profit is obtained by subtracting total cost (TC) from total revenue (TR). Under the assumption of the neo-classical theory, a firm will aim to produce a level of output where the difference between the total revenue and total cost is the greatest. The maximization of TR-TC is the equilibrium condition for a profit-maximizing firm. This is because once the firm is getting the most profit from a particular level of output and sales, it will not be incentivised to alter the level of output that is giving it the most yields in total investment performance.
A firm which strictly follows the primary assumption of the neoclassical theory of the firm will make its decisions on inputs and outputs based on the marginal effects of the components in the profit equation. Thereby leading economists to arrive at the conclusion that the condition for profit maximization to be achieved is when marginal revenue (MR) and marginal cost (MC) are equal, in other words, total profit reaches its maximum point where MC and MR intersect. This is also known as the second order condition. To maximize profit, all firms (not just competitive firms) must make two decisions. First, the firm determines the quantity at which its profit is highest. Profit is maximized when marginal profit is zero, or, equivalently, when marginal revenue equals marginal cost. Second, the firm decides whether to produce at all.
MC = MR means that a firm’s profits are the largest when the extra revenue gained from one more unit sold is exactly equal to the extra costs incurred from production the additional unit of output. A firm in a perfectly competitive market is a price taker. Regardless of the amount of output it sells, it cannot influence the market price so marginal revenue will be equal to average revenue, demand and price. It can be concluded that a firm’s profits are maximized at a level of output where its marginal revenue exactly covers its marginal cost.
Profit Maximization vs Shareholders Wealth Maximization
It is important to distinguish between profit maximization and shareholder wealth. The former is seen as a short term goal, to be achieved within a given period of time whereas the latter is more of a long-term objective. A corporation may maximize its short-term profits at the expense of its long-term profitability. In the short-run, decisions are made to ensure that profits are maximized, even at cost of the firm’s sustainability of survival in the long-run. For example, the company Purdue Pharma who manufactured a powerful narcotic painkiller OxyContin marketed the drug and claimed that is was not addictive even though the company’s executives knew it was a false claim. The company’s motive behind this unethical act was to boost sales and maximize profit in the short-term. However, this came at the expense of the company as Purdue Pharma and its executives were convicted of criminal charges and fined heavily. The company was destroyed in its effort to fulfill its short-term objective. Shareholder wealth is regarded as a long-term objective because shareholders are concerned about profits now as well as in the future and are therefore, interested in the sustainability of the firm.
In large corporations, the firm is run by directors and managers who are answerable to shareholders. Those who run the firm may not have interests, vision or goals that align with those of the shareholders. This perception is aided by the 25-year jail sentence handed down to former World.Com boss Bernard Ebbers for his part in the fraud that caused the $11 billion collapse of that company. They may prioritize maximizing short-term profits or even to maximize sales revenue as they may be driven by self-interest. In agency theory, the agent may be succumbed to self-interest, opportunistic behavior and falling short of congruence between the aspirations of the principal and the agent’s pursuits. Some firms pay their managers bonuses based on the year’s sales revenue or reward them with non-monetary benefits such as creature comforts. Higher sales revenue for the year means a bigger bonus or more benefits for this group of people. Shareholders on the other hand tend to be keener on the firm’s profitability in the long-run to ensure continuous returns on their investment. Managers do not stand to benefit directly from shareholder wealth maximization unless they own shares in the company itself. Thereby, giving rise to conflict between shareholders who own the firm and managers who run the firm. This conflict is called the principle-agent problem. This reinforces the view that under such circumstances, tension does exist to a certain extent.
To enable long-term profit maximization or shareholder wealth, short-term profit maximization may have to be forgone. Thus, tension may arise between these two objectives. This is so because investments, new capital, innovations, research and development for example, could assist in long-term growth and profitability and hence, maximizing shareholder wealth. However, in order to finance these long-term profit-making means, short-term profits may have to be sacrificed. On top of that, short-term profit maximization does not take risk into account and tends to neglect social responsibility which many economists would deem as necessary in pursuit of shareholder wealth maximization in the long run. High risk decisions may be considered favorable a long as they promise high returns even if they jeopardize the company’s image or well-being. Large banks especially those in the US were often used as proof of this matter when they made socially irresponsible and risky decisions by investing in sub-prime mortgages and derivatives. Whilst they made profits in the short-run, shareholder wealth was far from maximized in the long-run. Consequently, these banks suffered and many failed as backed by the extract from the New York Times. “Funds and banks around the world have taken hits because they purchased bonds, or risk related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or C.D.O.’s” (NY Times, 2007).
On the contrary, there might not be tension between these two objectives if short-run profit maximization was not the firm’s primary objective or if it was complementary to the long-run shareholder wealth objective. Theoretically, firms are assumed to possess information, market power and the incentives to determine output as well as pricing that would optimize profits. In the real world, firms are always faced with imperfect information about demand and cost conditions and uncertainty. Under such conditions, a firm may be contented with satisfying profits while making enough to ensure the ongoing growth and development of the firm which would contribute to shareholder wealth in the long-term. Large firms especially, have complex structures in which profit-maximization is a much too simple assumption to be made. Consequently, such firms would have other objectives on the top of their list such as revenue maximization, managerial utility maximization or maybe even seek to satisfy each goal rather than maximize as depicted by behavioral theories of the firm. However, it may be argued that shareholders would support the profit-maximizing goal and in return, the profits made would be reinvested in new investments, innovations and R&D projects. With respect to this theory, the more profit the company makes, the more funds are available for purposes which would enhance the value and price of the company’s shares in the future and hence, shareholder wealth.
Whether or not tension or conflict exists between short-run profit maximization and long-run shareholder wealth depends on several factors which ought to be taken into consideration. The size of the firm and its position in the market in terms of market share for example, could influence the nature and priority of its objective(s). The firm’s objective(s) may change in order of importance depending on the economy’s business cycle and health and the firm’s past and present performance. Firms may adjust the priority of their objectives in a quarterly or annual basis to suit current developments and progress of the firms of the firms with respect to their competitors. Also, different firms have a different structure and degree of complexity, governed by different groups of directors, managers and shareholders — all of which would influence their main objective. There is also the possibility that some modern-day firms follow a range of objectives and seek to satisfy rather than maximize. In large firms, the extent of divorce between ownership and control would influence the severity of the principal-agent problem when it exists. Some firms exhibit characteristics of Oliver E. Williamson’s model of managerial discretion which implies that managers design and implement policies in discretion to maximize their personal utility instead of aiming for the maximization of profits which at the end of the day, maximize shareholder wealth.
To conclude, the neo-classical model of profit-maximizing holds to a certain extent but in the real world, its assumptions are too simplistic to be coupled with the complexity of firms. Upon breaking down the assumptions of the neo-classical theory of the firm, profit-maximizing as the ultimate goal of firms may not be as logical as it seems. When shareholder wealth depends upon profits made in the short-run, the two objectives may be conflicting. In order to achieve shareholder wealth maximization, managers may have to make corporate decisions which would come at the expense for short-term profits. On the other hand, the two objectives can be a complement of the other if profits made in each time period are independent of each other. Short-term profit maximization could ultimately lead to long-term profit maximization and thus, shareholder wealth maximization. It is also possible that there may be little or no tension if profit maximization is not the firm’s main goal. Moreover, there are other alternatives which may be more viable and realistic in practice such as managerial utility maximization (Williamson), sales revenue maximization (Baumol), and objectives satisficing (Cyert & March). Either of these could go against long-run shareholder wealth and pose even greater threat to shareholders wealth.