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.
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 that the firm was operating on the inelastic portion of the demand curve (Levitt, 2006). In other words, price wasn’t being raised to respond to demand – and Levitt pointed out that the owner’s pricing decisions, based on inelasticity ended up costing the business owner 30% in profits (Levitt, 2006).
Why is this the case, then? Levitt says that while the owner has feedback from inventory and quality control, in any situation, a firm has really no direct feedback mechanism for determining whether it is pricing correctly (Levitt, 2006). Certainly, there is feedback if a business raises prices, but Levitt points out that it’s almost impossible to determine whether the right price has been found, because feedback may not be immediate (Levitt, 2006). The fact that this bagel maker comes closest to a pure profit maximization model, yet still doesn’t get it right, is interesting.
Furthermore, McKinney (2008) points out that for many businesses, pricing depends on more than output and demand – businesses, he notes, will often look at what the competition is doing and set prices according to a market rate. Going beyond basic profit maximization, companies will add cost-plus pricing – in other words, adding up costs, and then, on top of that, slapping on a profit margin (McKinney, 2008). Further complicating the scenario is the continued pitched battle between economic theorists and management accountants when it comes to profit maximization and any kind of pricing.
Lucas (1999) says that in one survey dealing with companies and pricing, only 18% of those surveyed used actually market-based pricing, while 70% of those asked used full cost-based pricing. As far back as 1939, he says, Hall and Hitch found that companies don’t work along the lines of marginalist, profit-maximizing principles when it comes to output (where MR = MC) (Lucas, 1999). Rather, companies were setting price by adding mark-up to full cost (Lucas, 1999).
Hall and Hitch pointed out that the reason for this was because producers don’t know their demand or marginal revenue curves, they don’t know, or understand consumer preferences, and producers, especially in an oligopolistic market, are uncertain what the competitor reaction would be to a price change (Lucas, 1999). Furthermore, most companies regard changing prices as a problem to implement, as it puts a burden on the salespeople, distributors and customers – and with profit maximizing behavior assuming price changes in response to demand or cost, such changes in price are more likely to be resisted than implemented (Lucas, 1999).
Lucas also points out that, while economic theory puts for the theory that profit is maximized by price-setting, in the real world, i. e. , the cost accounting world, identifying marginal costs is not only difficult, but difficult for management to understand (Lucas, 1999). The cost-plus formula tends to be easier when it comes to analyzing profits. It’s also easier to report to senior management and investors. Finally, Shmanske, in a 2006 write-up, points out that economists tend to be fairly simplistic when it comes to pricing models, pointing out that the price-taking model tends to come first.
There is a difference, he points out, between price-takers and price-searchers, considering all price-takers (i. e. , monopolistic tendencies) as “bad” and price-searchers(i. e. , free-market types) as good (Shmanske, 2006). However, Shmanske reminds us that the definition of monopoly isn’t necessarily that of a single company doing business in a market, but rather, that of a company (or industry) protected by the government from competition (Shmanske, 2006). Therefore, profit maximization in a monopolistic sense isn’t dependent on the market or demand – yet it still happens (Shmanske, 2006).
It happens, not because of inputs, outputs or demand, but because of lack of competition. The monopolistic company (or industry) can pretty much set whatever price it wants, depending on the good it has, because there is no competition to undercut its price or to make it have to rethink pricing decisions. Discussion Though the profit maximizing model is a nice one in theory (and probably a model that almost every company would like to adhere to), it simply isn’t a realistic scenario. Profit maximizing assumes that a company can set its own prices based on demand, as well as inputs.
The problem is, the competition is a huge question mark in this scenario. Getting back to Lucas, competition will likely react to a shift in price. If a company lowers its price in an attempt to get more customers into its door, the competition will likely do the same thing. If, on the other hand, it raises its prices, competition might do the same thing, for fear that its product will be seen as inferior. Furthermore, pricing is a very tricky scenario – it’s not necessarily just based on demand or perceived supply.
If a price is too low for a good, consumers will get suspicious. Too high, and consumers won’t want to buy it. Assuming, therefore, that pricing can be set by perceived demand as well as cost of inputs is only partially true. There is a lot more that goes into a costing formula than simply an understanding of costs and an understanding of demand, as important as those two things might be.
Basic economic states that firms will do what they can to get the most in profits, and this means a knowledge of inputs and demands. But as we saw, pricing is a tricky mechanism.
We noticed that, with our bagel-seller, there was a good grasp of demand and an understanding of necessary output – but he still didn’t get the pricing right. What was lacking was a feedback mechanism. And this is the great question mark when it comes to pricing – is what kind of feedback can the manufacturer receive. Though profit maximizing is a nice theory, that’s pretty much all it is. Very few firms can afford to make pricing decisions based solely on input and market demand. Pricing is more of an art that takes into many factors (such as competition).
But even in a monopoly situation, a firm is likely not to follow the profit maximization approach, understanding there are many components to a market that help determine pricing. In conclusion, therefore, profit maximization is a theoretical goal that a company would like to attain, but is not a very practical goal in reality.
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