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Objectives of a Firm: The Profit Maximization Model and the Economist’s Theory of the Firm

Why does a business exist? Most people would say “to make money”. Economists agree, and they build a whole theory around that idea. In this post, we will study the profit maximization model, the economist’s theory of the firm, and why modern thinkers also talk about other goals such as sales, growth and managerial satisfaction.

What is a firm?

A firm is a business unit that brings together land, labour, capital and organisation to produce goods or services and sell them in the market. A firm can be a one-person shop or a giant company. The economist’s theory of the firm tries to explain how a firm decides what to produce, how much to produce and at what price to sell.

The economist’s theory of the firm

The traditional (neoclassical) theory makes a few simple assumptions:

• The firm is run by an entrepreneur who is rational.
• The single goal of the firm is to maximise profit.
• The firm has full knowledge of costs, demand and market conditions.
• The firm works in a market with clear rules, such as perfect competition or monopoly.

These assumptions make the model easy to study, and it gives sharp, testable predictions.

The profit maximization model

Profit = Total Revenue (TR) − Total Cost (TC). A firm wants the output level where this gap is the largest. Economists give two ways to find it.

1. Total approach: compare TR and TC at each output and pick the output where TR − TC is maximum.

2. Marginal approach (the MR = MC rule): keep increasing output as long as the extra revenue from one more unit (marginal revenue, MR) is greater than the extra cost (marginal cost, MC). Stop when they become equal.

• If MR > MC, producing one more unit adds more to revenue than to cost, so profit rises. Expand.
• If MR < MC, the last unit costs more than it brings. Cut back.
• At MR = MC, profit is at its peak.

Two conditions for maximum profit

• First-order (necessary) condition: MR = MC.
• Second-order (sufficient) condition: MC must be rising at the point of equality, meaning the MC curve cuts the MR curve from below. Otherwise, the point might be a minimum-profit point.

Real example: a juice stall sells the 50th glass at an extra cost of ₹12 (ingredients, ice, cup) and gets ₹20 for it. MR is more than MC, so it makes sense to sell more. If the 90th glass costs ₹25 to make (the owner has to buy extra fruit at a higher price) but earns only ₹20, the stall should not push beyond that.

Criticisms of profit maximisation

• Real firms are not so sure about their costs and demand. Information is incomplete.
• Ownership and control are separate in big companies. Managers may pursue their own goals, not the shareholders’.
• Other goals matter: survival, market share, reputation, employee welfare and social responsibility.
• Time horizon: maximum profit this year may harm profits in the future.
• Firms often use satisficing, meaning “good enough” profit, instead of the highest possible.

Alternative models of the firm

Why still study profit maximisation?

Even with its flaws, the model is a useful benchmark. Over the long run, firms that ignore profit may not survive. And the logic of comparing marginal revenue with marginal cost is used by managers daily, even when they do not use the formal language.

Quick recap

• Traditional theory assumes a rational firm aiming at maximum profit.
• Profit is maximum where MR = MC and MC is rising.
• Alternative goals include sales, growth, managerial satisfaction and satisficing.

Read next (Part 4): Revenue Analysis: Total, Average and Marginal Revenue and Their Link with Elasticity