|Profit maximization is the most accurate description of managerial goal. The profit maximization is one of the very important assumptions of economic theory, which always assumes that a firm aims to maximize of profit. The attempt of an entrepreneur to maximize profit is regarded as a rational behavior. Hence, profit maximization continues to be a central concept in managerial economics.|
Total Revenue (TR) – Total Cost (TC) ApproachTotal revenue (TR) and total cost (TC) approach is the simplest method to determine the equilibrium of a firm. To calculate the profit of a firm, we find out the difference between the total revenue and total cost at difference levels of output. A firm is said to be in equilibrium when the difference between total revenue (TR) and total cost (TC) is maximum. Every rational producer will try to maximize his profit. We can find equilibrium of a firm with the help of this approach both under perfect and imperfect (monopoly) market competition.
i) Equilibrium of the firm under perfect competition
the firm is in equilibrium when it has no incentive to change its level of output. In perfect competition, a firm is said to be in equilibrium when it maximizes its profits (π), which is defined as the difference between total revenue and total cost.
The slope of TC curves reflects ‘U’ shape of the AC curve i.e. law of variable proportions. The firm maximizes its profit at the output ‘OX’, where the distance between TR and TC is the greatest. At the lower (OX1) and higher levels (OX2) than OX, the firm has losses. The TR-TC approach awkward to use when firms are combined together in the study of the industry.
ii) Equilibrium of the Firm under Imperfect Competition (Monopoly)
Marginal Revenue (MR) - Marginal Cost (MC) Approach
Criticisms/ Demerits of Profit Maximization Theory The objective has been criticized by some economists saying there may have other objectives in a firm such as sales maximization, welfare or satisfactions etc. this objective is criticized on the following grounds.
- Profit maximization criterion is vague and ambiguous. Profit may be long-term, after tax or before tax. It is not clear.
- In this objective, total profit earned during the life of assets and timing of their realization is ignored. Hence, equal value for earning realized on different periods is not realistic. It ignores the time value of money.
- This objective is concerned only with the size of profit and gives no weight to the degree of uncertainty of future profits. Two businesses with varying degree of risk and producing same size of profit is considered similar under profit maximization criterion. Thus, the risk element is ignored, which is one of the most important dimensions of financial management.
- This objective is incomplete because it ignores the appreciation in the value of securities or firm. Investors and owners of the businessmen are benefited not only by the earning of profit, but also due to the appreciation in the stock price.