Profit in Real Firms
A firm maximizes profits by setting marginal cost equal
to marginal benefit. However, when one examines real-world
firms, one finds few managers who make decisions by trying
to determine marginal costs and marginal benefits, and then
comparing them. In the 1960s, Business Week found a
case in which a firm did use marginal analysis, and decided
that it was unusual enough to be newsworthy. Continental
Airlines made decisions about which flights to fly by
comparing the extra costs of a flight with the revenues it
would generate. At the time, most airlines made these
decisions on the basis of the percentage of seats filled on
a flight.
Some economists have tried to construct a theory of the
firm in which the firm decides prices by a markup over
costs. The attraction of this sort of theory is that, when
asked to explain how they determine the prices they charge,
most sellers talk in terms of markups (which they sometimes
call "profit margins"). The problem with markup theories is
that they have difficulty explaining the percentage size of
the markup (when they bother trying to explain it at all).
Grocery stores, for example, mark up different products by
different percentages, and they have a much smaller average
markup than furniture stores have.1
Most economists see markup pricing as a rule-of-thumb way
in which businesses conduct their affairs. Firms usually do
not have the information needed to compute marginal costs
and revenues. Instead they find rules or guidelines that
work and stick with them as long as they perform
satisfactorily. If a firm marks up a product by 50% and
finds that it does not make a profit at that price, it tries
another percentage. When it finally finds a markup that
generates a profit, it will stick with it. Real businesses
rely much more on trial and error than on
sophisticated, mathematical analysis.
Even if firms do not attempt to set marginal cost equal
to marginal benefit, and even if they do not attempt to
maximize profits, they may end up doing so. In an industry
in which firms can enter easily, firms that have production
and pricing decisions far from those needed for profit
maximization probably will not survive long.
There is an analogy here to the theory of evolution.
Animals and plants that best find food sources and avoid
predators will survive and reproduce. As a result, one can
view the development of a species as a competition among
genes. A gene that gives the organism containing it access
to new food sources, better ways to exploit old food
sources, or better ways to avoid predation is more likely to
be passed on to the next generation (and thus survive) than
those genes that are competing with it in the gene pool. It
is not the intention of genes to do these things, but the
result is that genes act as if they maximize, and biologists
have found that analysis assuming that genes maximize their
chances for survival can give insights. Similarly, in a
competition for profit, those firms that do maximize,
whether intentionally or by accident, stand the best chance
of survival and growth. As a result, firms may end up close
to decisions on output and price that they would have made if
they knew their marginal costs and marginal benefits and
made decisions based on them.
Finally, a firm that explicitly sets out with a goal of maximizing profits may actually do
less well than one taking an indirect approach to this goal.
Setting up a goal such as "quality at a reasonable price"
may be better for both employee morale and consumer
reception than a more straightforward "profit-first"
goal.
The result that firms maximize profits, or come
reasonably close to it, is important when asking how well
firms that maximize profits serve the public interest. It
also allows predictions about the effects of government
restrictions and controls, one of which is discussed in the
next section.
1Mathematically one could
determine the optimal markup for each product. However, this
will result in maximizing profits and will give a solution
identical to the marginal-cost marginal-benefit solution. It
is subject to the same criticism the marginal-cost
marginal-benefit solution is subject to: it does not seem to
describe the way real-world firms actually set
prices.
Copyright
Robert Schenk
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