Why firms pursue maximum profit

Overview

Retained profit an attractive source of finance for expansion, profit act as a signal in a market economy and threat of takeover push firms towards maximising profit.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why is profit maximisation the standard assumption about what a firm is trying to do?

   Model answer

   Profit is the residual left for the owners after all costs are met, so maximising it maximises the return to those who bear the risk of the enterprise. It also gives a single, measurable objective that can be represented by a clear rule, namely producing where marginal revenue equals marginal cost. Firms that do not pursue it risk being outcompeted or taken over by those that do.

2. 2

   What output rule does a profit-maximising firm follow, and why does it work?

   Model answer

   The firm produces the output at which marginal revenue equals marginal cost, with marginal cost rising through marginal revenue. While an extra unit adds more to revenue than to cost it raises profit, so the firm should make it; once an extra unit adds more to cost than to revenue it lowers profit, so the firm should not. The turning point where the two are equal is therefore the profit maximum.

3. 3

   What three distinct reasons do the owners of a firm have for wanting profit to be as high as possible?

   Model answer

   Profit is the source of dividends, so higher profit raises the income shareholders receive from their investment. Retained profit is the cheapest source of finance for investment, since it avoids interest payments and the dilution of ownership that issuing new shares involves. Higher expected profit also raises the share price, so owners gain a capital gain as well as an income.

4. 4

   Why is retained profit an attractive source of finance for expansion?

   Model answer

   It carries no interest cost and no obligation to repay, so it does not raise the firm's gearing or its vulnerability to a rise in interest rates. It requires no new shares, so existing owners keep full control and their stake is not diluted. It is also immediately available without the delay, disclosure and fees involved in raising external finance.

5. 5

   How does profit act as a signal in a market economy?

   Model answer

   Supernormal profit indicates that consumers value the output of an industry more highly than the resources used to produce it are worth elsewhere, which attracts firms and resources into that industry. Losses indicate the reverse and drive resources out. Profit therefore performs a signalling and incentive function that guides the allocation of scarce resources without any central direction.

6. 6

   Why does the threat of takeover push firms towards maximising profit?

   Model answer

   If a firm earns less profit than its assets could yield, its share price falls below the value those assets would have under better management. That gap makes it an attractive target for a buyer who intends to raise profit and capture the difference. Managers who wish to keep their jobs therefore have an incentive to raise profit towards the maximum before someone else does it for them.

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