Profit Maximization

Topics: Economics, Profit maximization, Pricing Pages: 5 (1854 words) Published: November 4, 2011
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Though many people equate economics with finance and accounting, it's actually a social science, a study of behavior and how rational people behave when it comes to allocation of resources. Within the study of that social science are many theories in which economists attempt to explain the movement of prices and production, goods and services. In determining this, economists come up with many theories, but some don't have a very good connection with the real world. One of the more prevalent topics under discussion has been that of profit maximization. Economists use this theory to explain how firms set prices for particular goods or services. The idea behind profit maximization is that a company in business to maximize profits will need to know how much labor and capital to use to obtain the most profit from a venture. Once the input costs are realized, the company can then charge the right amount to take into account the costs, plus a reasonable profit. Profit, in its most basic term, is defined as the difference between a company's total revenue and total opportunities costs – while total revenue is the amount of income that is earned through selling products or services (Skaggs, 2008). Meanwhile, total opportunity costs involve input costs into the production processes as well as the value of highest-valued alternatives to which resources can be dedicated (Skaggs, 2008). On when a firm understands the marginal costs of producing a good or service, as well as demand elasticity, can price be set for profit maximization. Or at least, this is the theory. Most theorists believe that profit maximization is a real objective of a company. The belief here, in fact, is that companies will focus solely on costs when it comes to setting prices – and this is the way that companies determine how much to charge. Certainly, companies want to maximize profits to the extent that they are able. However, making profit maximization a hard-and-fast and reality-based objective simply won't work. As we'll see in this paper, there are simply too many variables in the real business world to take the profit maximization model seriously as a business tool or as something that companies might use on a regular basis. Literature Review

One of the more interesting case studies dealing with examples of profit maximization involves bagels and donuts – and was conducted by University of Chicago economist Steven Levitt. Dr. Levitt examined a business in Washington D.C. that sold and delivered donuts and bagels, with customers buying the goods on the honor system, depositing their payment in a lock box (Levitt, 2006). Dr. Levitt believed that this business probably represented the best model for examination of a profit maximization scenario, because it sold one product, and quantity produced on a daily basis was done so based only on demand. After examining 13 years of data from this company (representing more than 80,000 deliveries), Dr. Levitt noted that the owner was close to maximizing his profits in terms of choosing correct quantities, based on historical evidence and the owner's understanding of the market demand (Levitt, 2006). The owner had an uncanny knack of producing pretty much the right amount of bagels and donuts for sale. Though Levitt lauded the business owner for taking the information received on a daily basis regarding the quantity demanded by the customer, "the firm does a poor job of pricing," the economist acknowledged (Levitt, 2006). There were only four price increases over the 13-year period examined (Levitt, 2006). Yet every time the price increased, both the quantity of the product delivered and the goods consumed declined (Levitt, 2006). Still, profits rose substantially – leading Levitt to point out...

References: Levitt, Steven D. (2006) An Economist Sells Bagels: Profit Maximization in Practice. Capital Ideas. University of Chicago, Booth School of Business. Retrieved 2009, March 11 from
Lucas, Mike (1999, June). The Pricing Decision: Economists Versus Accountants. Management Accounting, 77(66), 34-35.
McKinney, Robert A. (2008). Pricing to Maximize Total Profits: Gross Profit Margin vs. Net Profit. Retrieved 2009, March 11 from
Shmanske, S. (Winter 2006). The Monopoly Nonproblem: Taking Price Discrimination Seriously. Independent Review, 10(3), 337-351.
Skaggs, Neil (2008). Profit Maximization. Illinois State University, Department of Economics. Retrieved 2009, March 11 from
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