Why should firms profit maximise

20 marks

Introduction

• Profit maximisation occurs where marginal revenue equals marginal cost (MR = MC).

• Traditional economic theory assumes firms should profit maximise to survive, grow, and operate efficiently.

• However, this objective can be questioned due to alternative business goals and real-world constraints.

Paragraph 1: Profit maximisation ensures long run survival and competitiveness

Point:

• Firms should profit maximise in order to ensure long run survival in competitive markets

Explanation:

• Abnormal profit provides the financial buffer needed to cover costs, withstand demand shocks and compete against more efficient rivals

Example:

• During covid, many experienced sharp falls in demand due to lockdowns, it was essentially a survival of the fittest

Analysis:

• Firms that fail to profit maximise may be unable to reinvest or cut prices, making them vulnerable to competitors.

• In competitive or contestable markets, inefficient firms are likely to exit, meaning profit maximisation becomes necessary for survival rather than choice.

Evaluation:

• However, firms may accept lower profits in the short run to gain market share or survive economic downturns, suggesting profit maximisation may be a long-run objective rather than a short-run one.

Paragraph 2: Profit maximisation enables investment, growth and economies of scale.

Point:

• Firms should profit maximise because profits fund investment and long term growth

Explanation:

• Retained profits can be used for capital investment, research and development and expansion into new markets

Analysis:

• Higher profits allow firms to expand output and benefit from economies of scale, reducing unit costs and increasing efficiency.

• Lower costs improve competitiveness and reinforce profitability, creating a virtuous cycle of growth and profit maximisation.

Evaluation:

• However, excessive growth may lead to diseconomies of scale, such as management inefficiencies, which can increase costs and reduce the benefits of profit maximisation.

Paragraph 3: Profit maximisation aligns with shareholder interests and economic efficiency

Point:

• Firms should profit maximise to meet shareholder expectations and promote economic efficiency

Explanation:

• Shareholders invest to receive dividends and capital gains, both of which depend on profits.

• Profit maximisation encourages firms to minimise costs and allocate resources efficiently.

Analysis:

• Firms that profit maximise are incentivised to be productively efficient, reducing waste and responding to consumer demand.

• This can improve overall welfare through lower prices or better-quality goods.

Evaluation:

• However, in firms with separation of ownership and control, managers may pursue alternative objectives (e.g. sales maximisation or satisficing), meaning profit maximisation may not always dominate decision-making.

Profit maximisation diagram

Shift in AD diagram