The theory of the firm vs. Short-term profit maximization

The theory of the firm vs. Short-term profit maximization

 

According to a microeconomic concept of firms, firms exist and make economic decisions mainly to maximize profits. It is the interaction between businesses that determine pricing, supply and demand which eventually lead the firms to allocate resources efficiently for profit maximization. The theory of the firm reflects the behavior of consumers—just like consumers seek to maximize their utility, firms take collective action to maximize their profit (Hart, 1988). In the process of such profit accruing actions and decision making, firms take on either short-run or long-run motivations for their decisions. The theory of the firm takes a more long-run and standardized approach of a firm where as short-term maximization relies on more immediate, short-run motivations. In order to aim sustainability and flexibility in fast-chasing market conditions, firms should rely more on the benefits that the theory of the firm guarantees than short-term profit maximization.

The theory of the firm is flexible in that its definition has been re-defined, re-analyzed and adapted in fast-changing economies. Originally, the theory of the firm, based on the economies of scale, is aimed at maximizing profits. This may be so for fledgling businesses and business start-ups even to present day. However, the current business trend is leaning toward increasing future, long-term profits. More firms look at the bigger picture in their investment by expanding expenditures in R&D, innovations and technology investment. With the rapidly-changing technological development, firms cannot compete by focusing only on short-term outcomes in this competitive market.

             The theory of the firm focuses on long-term motivations and sustainability whereas short-term profit maximization is driven by short-term motivations. Therefore, short-term maximization has higher transaction costs and is more risk bearing. Short-term profit maximization might not guarantee immediate returns even with high investment. Many MNEs tend to avoid short-run investment for profit maximization because the market change is very rapid and abrupt, and sustainable competitiveness comes from items, products, technologies, or services that look ahead of the future. Samsung Group, for example, focuses on the 10-year investment and production momentum, encouraging the invention of and investment in new future products. CEOs and management are no longer interested in short-term profit maximization, but they value the publicity of the company, sales maximization and public relations.

             Short-term profit maximization can be extremely frictional in competitive markets. When any investment moves disrupt the long-run equilibrium state of the market, there are huge risks involved both in the lifetime of the product and for the company’s reputation. Furthermore, what appears to be short-term profit maximization is in fact a result of years of investment and efforts in research and development, market studies, and technological innovations. Apple’s successful profit maximization is an example of how the introduction of a successful innovation can reward profit to the firm in the long run. However, in order for innovative products to score high sales records, the firm should take a long-term investment approach to enhance sustainable competitiveness and to eliminate excess market competition.

             The theory of the firm, however, also holds some limitations. Originated from William Baumol (1959)’s managerial theories of the firm, Oliver E. Williamson (1975) finds that managers seek their own interest rather than the firm’s which contradicts the firm’s behavior in profit maximization. This concept, later coined as ‘principal-agent’ analysis, emphasizes the difficulty of predicting the behavior of the agent that is a manager or supplier. Furthermore, to some extent, established firms seem no longer interested in profit maximization; they are simply satisfied in their market status, which Herbert Simon (1949) coined as ‘satisficing behavior.’ Yet, for those stagnated businesses, an abrupt short-term untested profit maximization approach can do more harm than good.  

             Despite those limitations of the theory of the firm, no other theories, let alone the short-term profit maximization approach, can replace the operational aspect of the theory of the firm. It is so-called a central theme of managerial economics for long-term value creation. When looking at corporation as a human community built on trust and respect, one can safely conclude that the long-term rules and intuitive decisions by rule of thumb supersede the marginalist principles of profit-maximization/cost-minimization in running organizations.

 

 

 

References:

 

Baumol, W. J. (1959) Business Behavior, Value and Growth. New York: Macmillan.

Hart, Oliver D. (1988) ‘Incomplete Contracts and the Theory of the Firm’, Journal of Law, Economics, and Organization, 4 (1), pp. 119-139.

Salvatore, D. (2006) Managerial economics in a global economy. 6th ed. New

York: Oxford University Press.

Simon, H.A. (1949) ‘Theories of decision-making in economics’, American Economic Review, 49 (June), pp. 253-283.

Williamson, O. E. (1975) Markets and Hierarchies: Analysis and Antitrust Implications. New York: The Free Press.