In economics, profit is the difference between a firm’s revenue and the costs it incurs to produce goods or services (Begg et al., 2020). The main goal of any business is to generate profits, which can be used to reinvest in the business, pay shareholders, or provide other benefits for the owners.
Two main models guide firms in their decision-making: the profit maximization model and the shareholder wealth maximization model. The profit maximization model is based on the idea that firms should make decisions to maximize their profits. This means that firms should produce the number of goods or services that will generate the most revenue while incurring the least cost. The shareholder wealth maximization model is based on the idea that firms should make decisions that will maximize the wealth of their shareholders. This means that firms should make decisions that will maximize the value of their shares, which can be done by increasing profits, paying dividends, or repurchasing shares.
Both models have their advantages and disadvantages. The profit maximization model is simple and easy to understand and provides a clear goal for firms to maximize their profits. However, it can lead to sub-optimal outcomes, as firms may make decisions that maximize their profits but do not benefit society. The shareholder wealth maximization model is more complex, but it considers the interests of all stakeholders, not just the firm’s owners (Denis, 2019). This can lead to better outcomes for society, but it can also be more challenging to implement.
Several criticisms can be leveled at the view that the primary objective of commercial firms is profit maximization. Firstly, it is often argued that firms are motivated by various objectives, including market share, growth, and survival, rather than profits (Amihud & Jacob, 1979). Secondly, even if firms are motivated by profits, it is often not possible for them to maximize profits in the short run due to the need to invest in long-term projects, such as research and development or advertising (Findlay & Whitmore, 1974). Finally, it is also argued that firms often face constraints, such as government regulation, which limit their ability to maximize profits.
Despite these criticisms, there is still a solid case to be made that profit maximization is an essential objective for commercial firms. Firstly, profits are a crucial source of revenue for firms, so firms need to be profitable to survive and grow (Colander, 2017). Secondly, profits can be used to finance investment in long-term projects, such as research and development, which can lead to even greater profits in the future (Damodaran, 2017). Thirdly, pursuing profits can often lead to innovation and efficiency as firms seek new and better ways to produce goods and services. Finally, economics can help assist firms in achieving their objectives by providing a framework for thinking about how to allocate resources in order to maximize profits (Sloman & Jones, 2017). In particular, economics can help firms understand the trade-offs they face and make decisions about how to best use their resources.
References
Amihud, Y. and Jacob Kamin, J. (1979). Revenue vs. Profit Maximization: Differences in Behavior by the Type of Control and Market Power, Southern Economic Journal, 45, 3, 838-846.
Begg, D, Vernasca. G, Dornbusch. R, and Fisher. S. (2020) Economics (12th ed) McGraw-Hill.
Colander, D. (2017) How to Market the Market: The Trouble with Profit Maximization, Eastern Economic Journal, 43, 362–367.
Damodaran, A. (2017). Response to How to Market the Markets: The Trouble with Profit Maximization, Eastern Economic, 43, 368–369
Denis, D. (2019). The Case for Maximizing Long-Run Shareholder Value, Journal of Applied Corporate Finance, 31, 3, 81–89.
Findlay, III, M. & Whitmore, G. (1974). Beyond Shareholder Wealth Maximization, Financial Management, 3, No. 4, 25–35.
Sloman, J, and Jones, E. (2017). Essential economics for business (5th ed.).
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