The concept of profit maximisation

Profit maximisation occurs when a firm achieves the largest possible gap between its total revenue and total costs, which includes a normal level of profit to cover basic operations.

Key features of profit maximisation

• Break-even output - This is the point where a firm earns just enough normal profit to cover all costs, meaning no supernormal profit is made.
• Supernormal profit - Most firms aim for this extra profit in the short run as a reward for the risks involved in running the business.
• Profit maximisation rule - Firms maximise profit where marginal cost (MC) equals marginal revenue (MR). At this point, the cost of producing one more unit matches the revenue gained from selling it.
• Producing below optimal output - If output is too low, the firm misses out on potential profit because MR exceeds MC.
• Producing beyond optimal output - If output is too high, the firm incurs losses on additional units because MC exceeds MR.

Reasons why firms may not maximise profits

While profit maximisation is a common goal, many firms do not operate at this level due to practical challenges and strategic considerations.

Factors preventing profit maximisation

• Challenges in identification - It can be hard for firms to pinpoint the exact output level where MC equals MR.
• Cost-plus pricing - Firms often add a fixed profit margin to the average total cost, which rarely leads to the maximum possible profit.
• Long-term vs short-term conflicts - Focusing on short-term profits might harm long-term growth or stability.
• Regulatory concerns - Firms with significant market share may limit profits to avoid attracting scrutiny from regulators.
• Market entry risks - High supernormal profits can draw in new competitors, particularly if barriers to entry are low.
• Stakeholder impacts - Excessive profits might harm relationships with customers (through higher prices) or employees (through lower wages).
• Principal-agent problem - Managers (agents) may pursue different goals than owners (principals), such as personal benefits over maximum profits.

Survival as an alternative objective

Survival is a short-term goal where a firm focuses on minimising losses during unexpected challenges, rather than pursuing profits.

Characteristics of survival objectives

• Response to threats - Firms adopt this when facing sudden external issues, like economic downturns, by covering variable costs even if total costs are not met.
• Strategic recovery - This approach gives the firm time to create a plan for returning to profitability.
• Closure decisions - If variable costs cannot be covered, shutting down is usually the most practical option to avoid further losses.

Profit satisficing as an alternative objective

Profit satisficing involves aiming for an acceptable level of profit that meets the needs of shareholders and other stakeholders, rather than the absolute maximum.

Features of profit satisficing

Stakeholder considerations:

• Firms are seen as groups of interests, where different parties have their own goals.
• Workers may seek better pay and working conditions.
• Managers might prioritise job security, status, and perks like company cars.

Risks involved:

• In firms with stable, high market share, this can lead to complacency.
• This includes ignoring rising costs or failing to innovate.

Sales maximisation and revenue maximisation as alternative objectives

Some firms prioritise increasing sales volume or total revenue over profits, often linked to managerial incentives or growth strategies.

Sales maximisation

Sales maximisation focuses on boosting the number of units sold, rather than revenue or profit.

Characteristics of sales maximisation:

• Output levels - This results in higher production than revenue maximisation, often up to the break-even point where total revenue covers total costs.
• Cross-subsidisation - Profits from successful areas can support losses in others to maintain overall sales.
• Links to growth - It can help expand market share and achieve economies of scale.
• Competitive tactics - May involve predatory pricing to block new entrants or eliminate rivals.

Revenue maximisation

Revenue maximisation emphasises increasing total income, often due to the separation between ownership and management.

Characteristics of revenue maximisation:

• Principal-agent link - Managers may favour this if their pay is tied to revenue rather than profits.
• Output decisions - Production continues until marginal revenue (MR) reaches zero, leading to more output than profit-maximising firms.
• Cost considerations - Firms will produce even where marginal cost (MC) exceeds MR, as long as MR remains positive.