According to the theory of the firm, the managements ultimate objective is to:

The term theories of the firm deal with the collation of theories that attempt to explain how business firms behave under various market structures. There are different market structures in which a business firm has to conduct its undertakings and which directly affect the firm’s objectives. Every business firm has a goal or an objective.

The firm has to fulfill different objectives like profit maximization, value maximization, sales revenue maximization, cost minimization, and so on within a given market structure and business environment. Thus theories of firms explain the behavior or working pattern of business firms to get their objectives being fulfilled within the existing structures and mechanism of the market. Basically, there are three types of major market structures in which a firm has to run its business activities. They are perfect competition, oligopoly, and monopoly.  

The theory of firm answers the major issues like why the firms do emerge in the market, what kind of transactions they do perform and they have to perform, why they have to fit themselves into a particular structure of the organization and market, what should be the relation of the firms with other firms and stakeholders and what drive them to do better and better performances.  

Meaning of Firm

A firm is an organization that converts raw materials into output. The primary activity of the firm is to proceed with raw materials into finished goods with the help of various factors of production within a given market structure. The firm hires the factors of production and transforms materials into saleable output in the market.

So, the firms are there to link raw materials and finished goods in a systematic and well-structured group formed by risk-bearing and skillful personnel. Therefore, the firm is a collection of resources that is transformed into products demanded by consumers. Basically, firms do produce different goods and services for profit. Profit is the difference between revenue by the firm and the costs incurred. 

Goals or Objectives of the Firm

Every business firm has its own goal or objective. After fixing the objective, it guides the decision-making of the firm. In the past, profit maximization was regarded as the sole objective of the firm. But, in modern society, a firm may have multiple objectives though some may get more priority and take over others.

In modern days, employees’ welfare, an obligation towards consumers, and the community are also said to be the objectives of a firm. Similarly, a firm may have the goal of minimization of costs or maximization of sales. In all cases, the decision will have to be made in an optimum manner so as to attain the objective efficiently.

Normally it is almost impossible to achieve all of these goals at once. The firm cannot keep all the goals at the level of the same priority. The firm must choose one of these three objectives. The main objectives of a firm have been discussed as below;

Profit Maximization

To examine the profit-maximization goal of the firm there is a model developed by a classical economist named Profit Maximization Model.

Profit Maximization Theory of the Firm

Profit maximization is one of the most important assumptions of economic theory. In economics, it is always assumed that a firm’s rationality is the maximization of profit. It means, rational producer or entrepreneur always attempts profit maximization. Thus profit maximization constitutes a central and crucial concept in the theory of the firm.

The profit maximization model as a goal of the firm or profit maximization theory of the firm was developed by classical economists. It means the classical and neo-classical economists regarded profit maximization as the most important and primary objective of the firms. According to them, profit is the core concern of the business firm and it is necessary for the existence and survival of the firms.

The profit maximization model is considered as a traditional and classical objective of the business firm. The model defined profit as the gap between revenue and the total cost of the firm.

Profit (P) = (TR-TC)

Where,

P= Total Profit (Economic Profit)

TR= Total Revenue (Price *Output)

TC= Total Cost (Explicit Cost + Implicit Cot)

As per the model, profit is the main reason behind the business undertaking of the firm and it is necessary to operate the economic activities of the business firm. It means profit works as the motivating factor for the entire business firm and its operation. This model is the most popular and profit maximization is a universally accepted objective by business firms.

Assumptions

The profit maximization theory of the firm or profit maximization model is based on the following assumptions:

• The firm is an individual enterprise and produces a single commodity
• The entrepreneurs act rationally or producer is rational (here rationality refers to the behavior of the producer and which requires that the producers attempt to earn/maximize the profit as much as possible)
• The owner itself is the manager of the business firm
• The factor price is given and constant
• The market is imperfectly competitive
• The time period is static
• Each unit of each factor of production is equally efficient

Approaches to studying the model

There are two approaches to examine the firm’s profit maximization condition or two methods to deal with the profit maximization theory of the firm. Here the profit maximization condition of the firm is known as the firm’s equilibrium of producer’s equilibrium and we have two different approaches to define such a point of equilibrium of the firm.

One is the old and traditional method called the total revenue total cost approach and another is the marginal revenue and the marginal cost approach. From a mathematical point of view, both of the methods are the same, or marginal cost or marginal approach is derived from of total cost total revenue approach. TR-TC approach is considered as the traditional approach and under both approaches, we see how the firm could maximize its profit by converting raw materials into finished goods.

Total Revenue-Total Cost/Total Approach

This is a traditional approach to measure the equilibrium point of the entrepreneur or profit maximization point of a particular business firm. According to the approach, profit is maximized when there is a maximum gap between the total revenue of the firm and the total cost of the firm. It means there is no range for either rising the income or tumbling its loss by shifting the quantity of the output.

Here, we may have the following three conditions;

The firm always wants to hold the first condition and wants to make the possible maximum gap between total revenue and total cost. The detailed procedure can be explained with the help of the following graph;

The above figure shows the profit maximization model under the total approach. The X-axis shows the levels of output and the Y-axis shows total costs and total revenues. TC represents the Total Cost Curve and TR represents the Total Revenue Curve.

In an imperfect competition market, the entrepreneur can generate more revenue when there is less price and earn more profit. It means there is a negative relationship between price and quantity of output and as a result total revenue curve initially increases at a decreasing rate, reaches its maximum point and it finally starts falling and it slopes upward to right from the point of its origin. The total cost curve is inverse S-shaped, i.e. total cost curve increases at a decreasing rate, and after a certain level of output, it increases at an increasing rate due to the operation of the law of variable proportions.  

Total revenue and total cost curve intersect with each other at points A and B and these points are known as break-even points. Here break-even point shows the situation where there is neither profit nor loss. At a point, A and B total revenue is exactly equal to total cost and there is no profit or zero profit.

Left to the part of Q1 or point A and right to the part of Q3 or point B, there is a loss for the firm as the total cost is greater than the total revenue for the firm. So, the firm has to bear the loss if it produces less than OQ1 and more than OQ3.

Thus in between Q1and Q3 levels of output, the firm can generate profit as there is total revenue is greater than the total cost. The vertical difference between total revenue and total cost represents the profit. In between points A and B, there are different levels of profit but the firm can generate maximum profit at the point or at the level of output where there is a maximum gap between TR and TC.

In the above diagram at the output level of Q2 the firm can generate maximum profit as the vertical distance between TR and TC is maximum represented by MN or EQ2. Thus, the firm is in equilibrium or generates maximum profit by producing the OQ2 level of output.

Marginal Revenue Marginal Cost (MR-MC) Approach

Neo-classical economists developed the MR-MC approach. Under this approach, MR and MC are considered to find the maximum profit earning level of output. This approach states that for a firm to be in equilibrium two conditions should be fulfilled simultaneously. They are

First Order Condition (FOC): Marginal Revenue =Marginal Cost (MR=MC)

Second-Order Cost (SOC): Marginal Cost cuts Marginal Revenue from below (Slope of MC is higher than Slope of MR)

The MR-MC approach to profit maximization model can be explained with the help of the following diagram;

The above figure shows the marginal revenue-marginal cost approach to the profit maximization model. AR curve which is also a demand curve is drawn on the assumption of imperfect competition. MR curve is also downward sloping.

MC curve is U-shaped due to the inverse S-shaped total cost curve. MR and MC intersect or cut or equal to each other at point ‘a’ and ‘e’ and the first-order condition is fulfilled at both of the points.

The firm enjoys equilibrium or maximum profit at point e because at such point both of the conditions are fulfilled. At point ‘e’, MC cuts MR or MR is equal to MC, and MC cuts MR from below, and thus the firm can ensure maximum profit with a given level of output.

At point ‘a’ the first-order condition of profit maximization is fulfilled (MR=MC) but MC cuts MR from above and is the violation of the second-order condition.

Hence, the firm generates maximum profit with the Qe level of output and the generated profit is represented by the shaded area in the given figure. 

Mathematical Form of MR-MC Approach to Profit Maximization Model

Under the given model, the major objective of the firm is to maximize profit. So, the main objective function can be stated as;

Criticisms of the model

Profit maximization is a universally accepted and important objective or goal of the firm. Many economists consider the profit-maximization goal as the realistic and simple goal of the firm. They believe, firms are basically organized to earn a profit, and profit is the measure of success of a firm.

So, all the activities of the business firm are guided to earn profit as much as possible. However, the profit maximization theory of the firm is being criticized by several critics. Major criticisms are expressed as below;