How far is profit maximization the basic objective of a firm ? What are the reasons for limiting profit ?

How far is profit maximization the basic objective of a firm ? What are the reasons for limiting profit ?

Ans. The fundamental objective for the existence of a business organization is to create value for the shareholders. The key shareholders of any firm are its owners. The owners want to maximize their wealth by availing profitable business opportunities. Thus, maximization of profits is considered to be the

fundamental objective of a company. This implies that all decisions taken by the managers should contribute towards profit maximization). The firm can maximize its profit only at the point where its marginal revenue (MR) is equal to its marginal cost (MC). In other words, to maximize its profit, a firm must select the level of output for which the difference between total revenue (TR)

and total cost (TC) is the greatest. Profitability is essential for the survival of every business firm, because

inability to make sufficient profits leads to its gradual elimination. Profit in mathematical form is

given as,

τ = TR- TC

This principle is illustrated in fig. 4.7. Here the slope of the TR curve gives firm’s marginal revenue (MR), viz the change in revenue resulting from a one unit increase in output sold. While the slope of the TC curve gives firm’s marginal cost (MC), viz. the change in cost resulting from a one unit Y increase in output produced. The TR curve starts from the origin which means that when there is no

production, revenue is zero. It” goes on increasing with the increase iri output. The TC curve starts from a point which lies above the origin which means that even when there is no production, the firm has to incur some costs i.e. fixed costs.

profit maximization curves

It can be noted from fig. 4.7 that at low levels of output, profit is negative because revenue is insufficient to cover total cost (fixed and variable). However, with the increase in output, revenue rises more rapidly than cost and profit eventually becomes positive. Profit continues to increase until output reaches the level Q, At point Q, MR and MC are equal and the vertical distance between TR and TC curves, i.e. AB is the greatest. Thus, Q is the profit maximizing output level. Beyond Q, the cost rises more rapidly throne revenue, i.e. marginal revenue is less than marginal cost. Thus beyond Q, profit declines from its maximum value. Thus, for profit maximization MR should be equal to MC. This rule can

be derived algebraically as follows-

Profit τ = TR-TC is maximized at the point where an additional increment to output leaves profit unchanged, i.e.

trt

Business firms generally aim at maximizing profits. But there are reasons because of which firms limit profitability voluntarily, they are-

(i) To attain industry leadership, firms may opt for sales maximization instead of profit maximization.

(ii) To compete” with other competitors, firms may follow a policy of profit restriction rather than profit maximization.

(iii) In some case, firms may have to follow a policy of minimum profit, due to government legislations.

(iv) To maintain customer goodwill, firms may follow a policy of restricted profits by fixing low prices.

( v) To restrain demand for higher wages from employees, firms may follow a policy of restricted profit.

(vi) Some firms may prefer higher liquidity rather than profit maximization to achieve financial soundness.

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