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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

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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