Profit Maximization

The traditional theory of firm’s behavior assumes that the objective of firm owners is to maximize the amount of short run profits. Before we dwell on the pros and cons of this theory, it is imperative that we understand the meaning of profits. Profit is defined differently in business and economics. The public and business community defines profit as an accounting concept, where it is the difference between total receipts and the explicit (accounting) costs of carrying out the business; explicit cost is the payments made to the hired factors of production. This profit concept is gross of the implicit cost, which stands for the imputed cost of the self owned factors of production employed in the business. The economic profit is the residual after both the explicit costs are deducted from the total receipts. To illustrate this important distinction let us consider an example.

A carpenter makes 100 chairs per month and sells them at Rs 150 per piece. His expenses on rent of the shop, cost of wood and other material are worth Rs 5,000. He employs two workers whose monthly wage bills stand at Rs 2,400 and pays electricity bill of about Rs 500 per month. He has invested Rs 50,000 in the form of machines, tool and inventories in the business of which Rs 25,000 is from his own fund and the remaining Rs 25,000 is a loan from a bank at the interest rate of 18% per annum. Further, assuming imputed costs of his own time, his own shop and his own savings of Rs 25,000 for the month are Rs 3,000, Rs 1,000 and Rs 250 respectively. The various calculations would them be:

Total receipts = Rs 150 x 100 = Rs 15,000

Total explicit costs = Rs 5000+2400+500+25,000/12(0.18) = Rs 8,275

Total implicit costs = Rs 3000+ 1000+ 250 = Rs 4,250

Business (Accounting) profit = Rs 15,000 – 8,275 =Rs 6,725

Economic profit = Rs 15,000 –8,275 – 4,250 = 2,475

Thus, business and economic concepts of profit are different.

Economic profits are a powerful guiding force in the free enterprise system, particularly for a proprietorship firm. However, the present day world has both the private and public sector firms operating simultaneously, and most firms are either on a partnership basis or are corporations. The public sector firms are known to pursue social objectives, such as factor productivity and the supply of essential goods at reasonable prices. The partnership firms and corporations on the other hand care for non-profit criteria as well. Further, a firm is expected to continue for a number of years and it would be unwise for it to care for today’s profit only, particularly if it impinges on future profits. For examples, if short run profits were the only criterion, there would be no expenditure on research and development, and no one would care for creating good will through good customer service and products quality. Nevertheless, firms are designed to make profits and profit is at least one of the factors on the basis of which the performance of firms is evaluated.