Do firms always

profit maximise?

Mo Tanweer, Head of Economics,

The conventional
assumption in most economic
models is that firms profit maximise. This
article offers an analysis of why this may not
reflect reality. So what is profit maximisation?
It is best to think about whether an extra unit
of output should be produced or not. When
MR > MC, then the marginal profit is
positive. This means that there must be more
profit still to be made by producing another
unit of output, so the firm cannot be profit
maximising. When MC > MR, the marginal
profit is negative. This means the firm is
making a loss on that marginal unit. So if the
marginal profit is negative, this means by
reducing their output, and not making that
specific marginal unit, then total profit must
increase. Thus the firm cannot be profit
maximising. Hence profit maximisation is at
MC = MR. At this point, the marginal profit
is zero.
However profit maximisation may be sub-
optimal for firms because of constraints that
prevent them from achieving it, or because
circumstances mean it may actually be
undesirable. In reality, firms have a range of
objectives they could pursue, of which profit
maximisation is just one and we now consider
some of these.
Exam Board AS Unit A2 Unit
AQA  3(3.3.1)
3(3.3.1
Edexcel  & 3.3.6)
OCR  F583
WEJC  3(A)
CCEA  A2(1)
Int. Bacc. 1 (1.5 Higher Level only)
Cambridge Microeconomics (c)
Pre-U
Key words
Profit maximisation · Satisficing
Corporate social responsibility · Behavioural theories
Oundle School, considers why
firms pursue a variety of strategies
other than the usual assumption of
introductory microeconomic theory
G Satisficing – this is a term coined by ranked 4th and has an agreement to not
economist Herbert Simon in 1948, assert its patent on the HIV/AIDS drug
(combining ‘satisfy’ and ‘suffice’), when Stocrin in South Africa. Unless you are
he said that: “Whereas economic man very cynical, this is not in line with the
maximises, selects the best alternative profit maximisation mantra.
from among all those available to him, his
Starbucks have adopted Fairtrade: “In Mali,
cousin, administrative man, satisfices,
Fairtrade cotton farmers are receiving a
looks for a course of action that is
premium of 5%-10% over the open-market
satisfactory or ‘good enough’.” 1
price for their crops, as well as a minimum
Thus firms tend to adopt strategies that price guarantee should volatile prices drop
aim to achieve some acceptable minimum below a certain level.” 3 This leads to a
level of an objective, before turning to focus better reputation but higher costs – does
on other objectives. For example, profit this help or hinder profits?
satisficing is the idea that aiming to maximise
The UK National Minimum Wage is £6.31
profit may be unrealistic due to bounded
for adults aged 21 and over. But some
rationality, and so will aim to make some
firms pay more. The London Living Wage
minimum level of profit (to survive or please
(£8.80) is a voluntary agreement that over
shareholders) and then move to focus on
200 firms have signed up to in London to
other aims such as social responsibility.
pay above the NMW. Why pay more than
G Corporate social responsibility can be you have to? Either all firms are not driven
defined as: “actions that appear to further by profit concerns and some do focus on
some social good, beyond the interests of social responsibility; or they may be
the firm and that which is required by subscribing to the Efficiency Wage
law.”2 Pharmaceuticals companies have Hypothesis which states that wages
multiple targets. In 2012, GlaxoSmithKline above the market clearing wage rate create
returned £6.3 billion to shareholders and an incentive for workers to increase their
yet on the Access to Medicine Index productivity, prevent shirking, and reduce
(which independently ranks pharma- hiring/firing. Thus actually higher nominal
ceutical companies’ efforts to improve wages can lead to lower relative unit labour
access to medicine in developing costs and higher profits – coming back to
countries) it was ranked 1st. Merck was profit maximisation.
1. H. Simon, Administrative behaviour: A Study of the Decision
Making Processes in Administrative Organisation, Macmillan Co,
New York, 1948.
2. A. McWilliams and D. Siegel, ‘Corporate social responsibility: A
theory of the firm perspective’, Academy of Management Review
26: (2001) pp. 117–127.
3. The Fairtrade Foundation’s response to the Institute of
Economics Affairs 2010 report titled ‘Fair Trade Without The
Froth’.

10 Economics Today · March 2014


G Behavioural theories of the firm stress
the point that only in small independently-
owned firms where the owner is the
manager, can the focus be purely on one
objective. Larger companies are a coalition
of interests and thus actually aim to satisfy
different people, adopting a mix of
objectives (although which objective is
given highest priority may depend on the
power of different stakeholders). When
looking at Stagecoach’s 2012 Annual
Report it is clear it tries to please different
stakeholders. On the Business Highlights
page it offered a range of statistics:
“Dividend up 10%” (to appease share-
holders); “Shortlisted for two new UK rail
franchises” (to attract new investors), “Rail
customer survey results” (to appease
customers); and “Rail punctuality data” (to
appease the regulator).
Many management theories of the firm
observe that firms’ objectives are dynamic,
and the coalition of different interests, from
owners to managers, trade unions to
customers, government to shareholders,
determine strategies. At any point in time it
depends which stakeholder is particularly
dominant as to whether profit maximisation
will take priority over other aims. For example
in the 1960s, powerful trade unions caused
wages to be high whilst government legisla-
tion and mass unemployment weakened their
power in the 1980s, which lowered the share
of wages in company revenues. Powerful
activist shareholders with significant shares
like Carl Icahn and Warren Buffett are able to
sway management decisions with open letters
(most recently in Dec 2013 Carl Icahn was
unsuccessful in swaying Apple to do a
shareback scheme and to prevent Dell from
going private).
Some firms may not desire profit maxi-
misation because of the power of certain
stakeholders and ownership structure can
affect the objectives firms adopt – e.g. with
a user base of over 1.2 billion users, if
Facebook charged a penny a year, it would
net a sizeable increase in profit. But the CEO,
Mark Zuckerberg stated publicly in 2013:
“Simply put, we don’t build services to
make money; we make money to build
better services.” Facebook was “built to
4. Mark Zuckerberg’s letter to investors as part of the IPO filing
prospectus.
5. Club President Uli Hoeness.
6. http://www.theguardian.com/football/2014/jan/09/bayern-
munich-subsidise-arsenal-ticket-cost
Economics Today · March 2014
What does it depend on?
One could argue that all strategies are
ultimately short run sub-sets of long-
run profit maximisation – a cynic could
argue that even Social Responsibility
objectives are an attempt to maximise
market share, brand awareness, and
accomplish a social mission – to make
ultimately profits. Here are some
the world more open and connected.”4
relevant aspects:
Facebook prominently advertises that its
G The time frame – Firms can only
service is “free and always will be” on its
continue to exist if some level of
homepage. Given Mark Zuckerberg retains
profit exists. But many firms do not
62% of the voting rights, his way is the only
make profit in the early stages of
way currently.
their existence. This is particularly
The German Bundesliga offers cheap football true of technology start-ups. For
seats e.g. an adult ticket in the standing example, Skype – a firm created in
section of Bayern Munich home matches 2003; when it filed for an IPO
costs just £104 (Arsenal’s equivalent in in 2010, was still operating at a
London is at least £985). The chairman of $7 million loss. Twitter, which was
Bayern Munich was reported to have said in valued at $18bn at IPO in Nov 2013,
2013: had a loss of around $80 million in
“We could charge more than £104. 2012. Thus ‘profit max’ may be a
Let’s say we charged £300. We’d get relevant long run objective, but not
£2 million more in income but what’s possible in the short run. Indeed, in
£2 million to us? In a transfer discussion the short run it may be preferable to
you argue about that sum for five run at a loss, and aim for revenue
minutes. But the difference between maximisation or establishing a
£104 and £300 is huge for the fan. We brand presence and aim for growing
do not think the fans are like cows, who market share. Similarly, in a
you milk. Football is for everybody. recession, it may not be the best
That’s the biggest difference between us time to pursue profit maximisation
and England.” 5 – many firms absorbed the VAT hike
in 2011 given the state of consumer
In early January 2014 Bayern Munich confidence.
announced that the club intended to
G The market structure – A
subsidise part of the ticket prices for the
Champions League match against Arsenal monopoly firm lacking competition
due to take place on 19 February 2014.6 may have no incentive to maximise
profit whereas oligopolistic firms
Under chief executive Steve Jobs, Apple may, given the performance of its
never paid a dividend since his arrival in 1995 rivals. Firms in monopolistic indus-
preferring to use their cash – which was tries may be less likely to pursue
$100 billion last year (more cash than the profit maximisation, since many are
US government) – for investment growth independently owned and the
instead. However, under Tim Cook’s new market so competitive, they need to
philosophy this changed, and a quarterly be open to satisficing strategies.
dividend of $2.9 billion was distributed in However, such firms are also less
2013. Many start-up tech firms do not pay likely to be subjected to the
dividends preferring to re-invest that money Principal-Agent problem since the
back into their long term future, which could owner and managers are more
be in line with a long-term profit maximisa- closely linked. Thus they may be
tion aim. A survey completed in 2013 showed more able to adopt an outright
that 81% of existing iPhone users purchased objective such as profit maximisa-
another iPhone in the 12 month period tion, whereas in oligopolistic
surveyed. Apple could probably increase the industries, firms have so many
price of their iPhone by 5% and still retain stakeholders to consider, that profit
their customers. But they don’t. This points satisficing is a more realistic aim.
to the idea that profit satisficing is more Also, small firms may be concerned
common. primarily with survival, and short run
profits could be critical in this – the
luxury of being able to wait for
deferred long term profits may only
be the preserve of the established
multinationals.
11
 REMEMBER
THIS
Profit-maximising is just one of a range of strategies that
firms may pursue.
Firms’ strategies will vary in the short and long term and
also depend both on the competitive environment in which
they operate and the current stage of their own life cycle.
Profit-maximisation is a neat theory to assume but very
few firms achieve it – most profit-satisfice.

G The type of firm – It is generally accepted
that firms in the private sector are more
likely to pursue profit maximisation than
those in the public sector. The lack of
accountability in state agencies prevents
the need for cost minimisation. Institu-
tions like Railtrack are expected to aim to
achieve profit only after certain safety
objectives are met. The core principles of
the NHS when it was created in 1948 were
that it met the needs of everyone and that
it be based on clinical need, not ability to
pay. These principles prioritise objectives
beyond profit.
As for charities, a ‘not-for-profit’ charity
simply means that surplus revenues are
used to achieve its goals rather than be
distributed to owners. And given their
raison d’être is to maximise the amount
they can give to their cause, (donations
minus their administrative costs), this is
similar to profit maximisation. The fifth
largest charity in the UK by income
is Cancer Research (2012: Income
£536 million) with £372 million of their
income from voluntary donations raised at
a cost of £80 million. For Oxfam, the ninth
largest, it cost them £23 million
to generate voluntary donations of
£111 million. If these charities could find
a way of generating an extra pound of
donations (MR) for less than a pound
(MC), they should pursue it – thus ‘profit
max’ is applicable here too.
Some schools operate as charities whilst
others are for-profit institutions. Does this
mean that their approaches to profit
maximisation differ? Oundle School is a
registered charity and in 2012 made
revenues of £36 million with costs of
£26 million, with the £10 million ‘profit’
reinvested. MPW Sixth Form College on
the other hand is a ‘for-profit’ institution.
In 2010, MPW made £2.3 million on
revenues of £12.6 million. Whilst there may
be different objectives alongside profit
maximisation depending on their ethos,
both need to earn enough to survive. Many
schools offer bursaries – Harrow School’s
bursary fund provides £950,000 for
bursaries. Eton College is building a free
school where a fifth of places are to be set
aside for children from poor homes. The
university access watchdog – the Office for
Fair Access – found that universities spent
£591 million on bursaries between 2006-
2008. This is not consistent with profit
maximisation but instead social responsi-
bility goals. Cost-cutting may boost profits,
but would harm these objectives.
G There may be another self-interested
reason why firms may choose to profit
satisfice. In a bid to avoid attracting the
attention of regulators, firms may wish
to not try to profit maximise to extremes.
Florida has a law on price gouging that
prohibits excessive profit maximisation
strategies:
“During a state of emergency, it is
unlawful to sell necessary com-
modities for an amount that grossly
exceeds the average price during the
30 days before the declaration of the
state of emergency.”7
In 2012, Sony did a U-turn after being
accused of exploiting Whitney
Houston’s death by doubling the price
of her Ultimate Collection album just
24 hours after her death. In October
2013 when all gas firms in the UK tried
to increase prices to maintain profit
margins – MPs grilled representatives
from energy companies over price rises,
to the point where there was a partial
U-turn on proposed price hikes over the
Christmas period. By not maximising
profits, firms can stay ‘under the radar’
of the regulators like the OFT and away
from the consumer’s ire.

TRY
THIS
How might a football club adopt satisficing behaviour?
Research two firms in a specific industry. Put together a presentation
that illustrates what seems to be the different strategies these firms
have adopted.
On a Perfect Competition diagram, if you plot the MC in a particular
way, can you see that the MC = MR condition can be true in two places?
Thus MC = MR is actually a necessary but not a sufficient condition of
profit-maximisation. Can you work out the second condition that must
be true to profit-maximise?

7. http://myfloridalegal.com/pages.nsf/Main/5D2710E379 EAD6BC85256F03006AA2C5?OpenDocument

12 Economics Today · March 2014

 with Principal Examiner,
Robert Nutter

In recent years there has seen the emergence of ‘zombie companies’ – companies just
about surviving but with no long term future. Their survival is likely to be short term only
and possibly has a theoretical parallel with firms that can stay in business in the short
run only because their price is above average variable cost.
1. Explain the importance of the shutdown point for firms in the short run.
2. Investigate what is meant by a zombie company and how their objectives may be
different from more successful firms.
G Some firms may wish to profit maximise in 3. High Street retailers have had their share of zombie companies in recent years such
a first best world, but cannot in the second as HMV and Comet. Why might these firms survive in the months up to Christmas but
best reality. It is near impossible to fold in the early part of the following year?
determine price-output decisions in the
manner suggested by economic theory – http://www.insolvencyjournal.ie/news/britain's-zombie-army-of-the-walking-
the issue may be imperfect information commercial-dead-grows-to-227-000-companies#
as many self-employed may have no http://www.bbc.co.uk/news/business-24983378
understanding of the concepts of MR and http://www.drapersonline.com/news/weak-retailers-at-risk-when-january-bills-
MC curves; or there may be practical land/5055761.article
limitations in measuring these. The MR http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9807042/
and MC may not be obvious if there is no Jessops-HMV-and-now-Blockbuster-is-the-high-street-dying.html
market price on the output produced; or if
the output itself is not observable so it is
unclear what the marginal cost is. The MR
is likely to change as demand curves change
during the year and over the economic
cycle. Thus many firms adopt a ‘cost-plus
pricing’ strategy to ensure simply that a
loss is not made on the unit sold.
So why assume profit maximisation? It allows
for a starting point. Firms can only survive if
they make a profit and most will aim for this
in some way. Both Alfred Marshall’s concept
of Perfect Competition and William Baumol’s
concept of Contestability were not meant to
state reality but to offer a model from which
to compare real world behaviour. Similarly,
profit maximisation offers us somewhere
from which to base the rest of our analysis.

Economics Today · March 2014 13