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Economists conventionally assume that firms attempt to maximize profit. This assumption has been a source of controversy, in part simply because the word profit is a bit nebulous. One might think that it is well defined because each year thousands of firms announce to the public exactly what their profits are. Firms compute these profits by subtracting from their total receipts most cash outlays plus an allowance for depreciation of capital.1 Profit emerges as a residual--something left over after costs have been paid.

The problem that economists have with this definition is that it ignores implicit returns. The ma-and-pa grocery or restaurant may seem to have a profit when costs are subtracted from revenues, but this may be only because the owners do not pay themselves a wage. When their time is valued at even low levels, the "profit" may disappear. Or the family farm may have a profit, but only because it neglects to take into account a return on the land. If this return is computed on the basis of what rent could be obtained on the land, and if an allowance is made for the value of the farmer's labor, there may be little or no profit.

Much of corporate profit can reflect an implicit return on investment. If the corporation has a large investment in capital and this entire investment was financed by borrowing, then the return on capital is captured in the interest payments the firm makes. But if the investment is not financed by borrowing, then the return on it will be reported as profit in the income statement.

The economic definition of profit is the difference between revenue and the opportunity cost of all resources used to produce the items sold. This definition includes implicit returns as costs. Because profit is a surplus in this definition, it should not persist in industries in which entry is easy. Whenever a surplus exists, new firms should flow into an industry, bidding up the price of resources and bidding down the price of output until profit in the economic definition is eliminated. Profit should not exist in long-run equilibrium.

Profit does exist in the real world, and there are several explanations that economists have for it. Some economists simply consider it as an indication that the economic system is in perpetual disequilibrium. Joseph Schumpeter, for example, saw profit as a return to a successful entrepreneur. The entrepreneur who finds an opportunity where no one before him saw one, and takes advantage of this opportunity, will make a profit. However, this profit will be temporary because, as time goes on, others will follow him and erode his profit. Others see profit as an indication that forces of competition may not be strong and that in some industries barriers to entry exist. Still other economists have argued that profit is a special sort of implicit return, a return for bearing risk. Those who are willing to take more risk will, on the average, earn higher returns.

After one includes implicit costs as part of costs, an accurate measurement of profit is impossible, which is a major reason why accountants do not try to measure the economic concept of profit. This obviously causes problems if one wants to test whether or not firms try to maximize profits. An alternative way to approach the measurement problem begins with the Schumpeterian notion of profit, which is that it comes from the discovery of opportunity. A discovery of an opportunity should increase the discoverer's wealth. Thus, a way to measure profit is to try to measure unexpected changes in wealth--wealth increasing faster than a normal rate of return. If one sees people whose wealth is increasing more rapidly than it would if their assets were entirely in the form of high-grade, short-term bonds, one could conclude that they had found a profitable opportunity. There are measurement problems here as well, however. Much of people's assets are in the form of investment in themselves--human capital--and is not easily measured.

Do firms try to maximize profits? If profit is defined as accountants measure it, it seems unlikely that firms do. However, if costs are defined broadly enough, it must be maximized if the decision-maker is rational because profit is good for the firm. For example, suppose a humanitarian opened a business with a goal of helping the poor. He might keep prices below a level at which accounting profits are maximized. Yet one can argue that if the humanitarian raises prices, his (opportunity) costs increase because he must partially forgo the goal of helping the poor. Thus, with a loose enough definition of cost, one can argue that a very wide assortment of observed results are consistent with the assumption of profit maximization. (However, with a very loose definition of costs, the hypothesis will cease being a scientific hypothesis because it will not be open to refutation.)

Even if there were no definitional problems, there still would be a fundamental problem with the assumption that firms maximize profits. Most firms do not have a single decision-maker. Instead, they are made up of an assortment of individuals, each using the firm to attain his own goals. Managers pursue goals; stockholders pursue goals; blue and white-collar workers pursue goals; but the firm does not.

The assumption that firms attempt to maximize profits is inconsistent with the underlying methodology of microeconomics, which assumes that all decision-makers are individuals. Mainstream economists criticize Marxists (those who follow Karl Marx) for dealing in terms of class actions without grounding these actions on individuals pursuing goals. Given that most production takes place in firms that are large organizations, the assumption that firms attempt to maximize profits is open to the same criticism that mainstream economists make against the Marxists. The assumption that firms maximize profits also needs to be grounded on individuals pursuing goals.

One attempt to ground the assumption of profit maximization on individual behavior appeals to the principal-agent problem. An agent acts on behalf of another person, called a principal. How can the principal be sure that the agent acts in the principal's interest? The principal must restrict the agent in some way so that it is in the agent's interest to act in the interest of the principal. The most common way to do this is to tie rewards with performance.

Payment on a commission basis is an important way to solve the principal-agent problem. When one hires a lawyer to sue on a civil matter, an auctioneer to sell one's belongings, or a real-estate agent to sell one's house, or when a movie star hires an agent to seek employment, payment is done with commissions. When the agent does a good job, he or she is paid a lot. When the agent does a poor job, he or she is paid little or nothing.

Sometimes, the principal can protect himself with a contract that specifies how the task is to be performed and what the price will be. The ability to use the courts to enforce the contract protects the principal. Sometimes, the principal can protect himself by a threat to take the task elsewhere. This threat is effective if repeat business is important to the agent.

The principal-agent problem is one of control: how does the principal control those working on his behalf? Once one starts looking for cases of this problem, one finds them everywhere. How do shareholders control management, citizens control government, or management control employees? The principal-agent problem is everywhere because we live in a world of interdependence and specialization.

The principal-agent problem occurs in several places in the firm, including in the relationship between legal owners and hired managers. Stockholders own shares because they believe that this ownership will increase their wealth. Managers work for the firm primarily because it provides them with income needed to buy goods and services, and also because their positions provide them with prestige and authority. The threat of a takeover or hostile merger provides stockholders with their most effective constraint on managerial action. If managers perform poorly at making profits, shareholders will sell their shares because they will not achieve their goal of increasing wealth. The lower value of the company is an inducement for other management groups to buy out the company and replace management. If the new managers can improve performance, they can capture at least some of the increased value of the firm.

Next we consider the alternative assumption that firms simply try to survive.

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1This is the accounting definition of profit greatly simplified. There are in fact many technicalities that complicate this computation, but they need not concern us here.

Copyright Robert Schenk