Do Business Firms Maximize Profits?

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Chapter 6: “What Do Firms Try to Maximize, if Anything?”

Introduction

Do firms really maximize profit? This question has been under debate since the 1940s and 1950s, when a wide number of mainstream neoclassical economists defended the assumption against a group of institutional economists that questioned the assumption as the norm in the industry. On the side of the neoclassical economists were Fritz Machlup and Milton Friedman, with institutional economists Richard A. Lester and Garnder C. Means opposing them. While the debate remains largely unsettled, the fact remains that in practically all economic textbooks, the assumption of profit maximization remains prominent.

More recently, Fanny Demers and Michel Demers, two associate professors of economics at Carleton University renewed the debate with Mark Lavoie, a professor of economics at the University of Ottawa.

Profit Maximization and Other Goals of the Firm

Fanny Demers and Michel Demers argue that whether firms maximize profits is controversial, and dependent on several important factors. The market structure under which the firm operates, the form of business ownership, and level of certainty and information all affect whether or not a firm will seek to maximize profit.

Market Structure and Nature of Competition

The market structure under which the firm operates is very important when analyzing profit maximization. Perfect competition occurs in an industry when that industry is made up of many small firms producing homogeneous products, when there is no impediment to the entry or exit of firms, and when full information is available.1 Under such a market system, when competitive pressures are very intense, a firm is likely to pursue profit maximization, as market forces will push firms that do not into bankruptcy.

However, in imperfectly competitive markets, such as monopolistic competition, monopoly, and oligopoly, other goals that are not profit maximization may be pursued. Monopolistic competition refers to a market in which products are heterogeneous but which is otherwise the same as a market that is perfectly competitive.2 As each firm sells differentiated products, they can adjust its selling price, within limits, and compete with other firms in respect to quality, service, and warranty. Under such a market system, a firm may seek other goals, such as providing a superior product or service, as opposed to profit maximization.

A monopoly is when a single firm operates in the market. It can occur as a result of economies of scale, patents or special permits, among other things. Under such a market system, the monopolist may refrain from pursuing short-run profit maximization and lower prices to discourage entry by other firms, or to deter government intervention and regulations.

An oligopoly is a market dominated by a few sellers, at least several of which are large enough relative to the total market to be able to influence the market price.3 Oligopolists compete with price adjustments in the short run, and product innovation, design, quality, customer service and advertising in the long run. They may pursue profit maximization of the industry through collusion, profit maximization by the price leader or individual profit maximization. In addition, they may also seek a high market share so as to be able to lead the industry, rather than profit maximization.

Forms of Business Ownership

The form of business ownership of firm can also be an influence when analyzing profit maximization. The three main legal organizational forms for business are sole proprietorship, partnership, and corporation. A sole proprietor is a type of business entity that is owned and operated by one person, and in which there is no legal distinction between the owner and the business.4 A partnership is a form of organization established when two or more individuals agree to combine their financial, managerial, and technical abilities for the purpose...
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