Firms Maximize Profits

Firms Maximize Profits

At the expense of suspense, let me start by saying that the title of this piece does not reflect what I think about firms. There are many real-life examples of businesses that sacrifice profits to save the jobs of their workers or to refrain from harming the environment. The title is not an indication of my personal aspirations in the form of “firms of the world, maximize profits!” either. In any case, I do not believe that we as academics can dictate the objective of the firm. It is understandable that there is some criticism against the standard microeconomic models’ insistence on thinking of the firm as a profit maximizing entity. Under this assumption, the firm would only consider its revenues and costs when making its decisions, and ignore the other potential factors such as corporate social responsibility.

What is my defense for teaching models relying on profit maximization in my classes and using them in my research? An important part of the explanation is recalling that a model is not supposed to be a mirror image of reality. Each model builds on a bunch of assumptions, simplifying the complications of real life. A profit-maximizing firm is a handy modeling piece, because it allows the researcher to capture a very central feature of the economy. The economy is shaped by a collection of decisions made by different actors with different objectives. Whether the economy functions well depends on how society deals with the frequently conflicting interests of these decision makers, rather than ignoring their existence.

As an example to how models help us comprehend and perhaps change reality, take the standard textbook microeconomics model [1]. This model allows us to talk about how markets can aggregate the profit maximization objectives of the firms with the preferences of their consumers, and allocate limited resources to where they are needed the most. Of course, this is only true when some demandingconditions are satisfied. This is an economist’s way of saying when all the stars are aligned. Consider the example of industrial greenhouse gas emissions. Obviously, society’s needs do not explain the existence of firms emitting pollutants endangering the health of millions. That is why, this is a classic example to a market failure. Another classic example would be a concentrated industry, dominated by a few big players, using its market power to manipulate prices. The usefulness of the economic model comes from the suggestions it makes for correcting these failures. For instance, it follows from our humble textbook model that a carbon pricing method (in the form of a carbon tax or a cap-and-trade mechanism) would make even the most selfish of the producers avoid using the atmosphere as a dumpster [2]. Similarly, an effective competition policy run by a strong authority would curb the abuse of market power [3].

Suppose we decide to dismiss the economic wisdom that arises from models using profit maximization , blaming it as responsible for the problems we face today. What options would we have then to manage climate change or any other market failure? We could follow the elitist course and form a commission of specialists to deliberate on what the firms’ objectives should be. Even if the experts can agree on their recommendations, this would still leave us with the insurmountable task of measuring the firms’ compliance with what is asked of them. Alternatively, we could fall into the populist trap of categorizing firms as either good or evil according to the latest fashion of the day. Either way, our well intentions are likely to incite more greenwashing by the firms than actual impact.

Where do we go from here?

It is commendable that more and more people are becoming more and more aware of the failures of our current policies in coping with our environmental and societal problems. This provides a unique opportunity to improve how our society functions. But curing the ills we inflicted on nature will not come from ignoring our own nature. However well-informed or well-intentioned they may be, human beings will continue to have different preferences, different opinions, different values, different objectives. The analysis of our problems and the recipes we provide for their solutions will greatly benefit from taking a note of the existence of our conflicting interests. Profit maximization assumption is nothing but a useful way of portraying these conflicts in our models.

Further reading

[1] For instance, consider one of the models in The Economy, which is a recent textbook written by a collective of economists aiming to reconnect the teaching of economics with the real world challenges such as global crises, environmental degradation, and inequality.

[2] The idea that taxes can be used with the purpose of making firms internalize the impact of their activities on the rest of the society was first introduced by Arthur Pigou (The Economics of Welfare, 1932). 

[3] The pricing practices of firms with market power (monopolies, oligopolies) was first studied by Augustin Cournot (Recherches sur les Principes Mathématiques de la Théorie des Richesses, 1838).

 

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