Profit maximisation

Traditional economic analysis of the firm has long begun from the assumption that firms behave rationally and seek to maximise profits. This assumption serves as a baseline for understanding business behaviour because profit is a measure of success that can be clearly defined and quantified. Profit is calculated as total revenue minus total cost, and therefore, maximising profit means choosing the level of output and price at which this difference is greatest.

To understand why this matters, it is important to think about how a firm decides on its output when operating in a market. A firm receives revenue from selling its output, and the extra revenue it gains from selling an additional unit is called marginal revenue. At the same time, producing more output involves incurring costs, and the extra cost of producing an additional unit is called marginal cost. Profit maximisation is understood in terms of comparing these two magnitudes.

If the firm sells one more unit of output and finds that the marginal revenue it receives is greater than the marginal cost of producing that unit, then producing it adds to profit. The additional revenue outweighs the additional cost, and the firm becomes better off. In this situation, it makes sense to increase output. Conversely, if the marginal cost of producing one more unit exceeds the marginal revenue earned from selling it, then producing the unit reduces profit, as the firm spends more to make it than it gains from selling it. In this situation, it makes sense to reduce output.

This reasoning leads to the central profit-maximising rule. Profits are maximised at the level of output where marginal revenue is equal to marginal cost, so that no additional revenue can be gained, thus no additional cost is incurred, the final unit provides exactly zero change to balance. This is often written as the condition MR = MC. It applies to firms in any type of market structure, whether they are operating under perfect competition, monopolistic competition, oligopoly, or monopoly. The MR = MC rule provides a general principle that identifies the point at which profit reaches its highest possible level.

This diagram illustrates how the firm decides its optimal output. On the horizontal axis is output, and on the vertical axis is price, cost, or revenue per unit. The downward-sloping marginal revenue curve reflects the fact that, under imperfect competition, a firm must reduce price to sell more units, so the additional revenue per unit falls as output increases. The marginal cost curve is typically U-shaped, falling initially as economies of scale are exploited but rising after a certain point due to diminishing returns. The intersection of MR and MC identifies the unique output level where the gain from the last unit sold exactly equals the cost of producing it. At this point, any further expansion would add more cost than revenue, while any contraction would mean missing out on revenue that exceeds cost.

From the perspective of total revenue and total cost, the same logic can be expressed differently. Profit is the difference between total revenue and total cost. If marginal revenue exceeds marginal cost, then increasing output widens this difference. If marginal cost exceeds marginal revenue, reducing output narrows the loss and raises overall profit. The maximum gap occurs precisely at the MR = MC point.

It is worth emphasising that profit maximisation is not just a mathematical identity but also a practical guide. For managers and decision-makers within firms, the MR = MC rule tells them when to expand production and when to hold back. For example, suppose a firm is currently producing at a level where MR is greater than MC. This means that each additional unit adds more to revenue than it does to cost. Managers can then increase output to raise profit. Eventually, as output rises, MC tends to increase while MR tends to fall, and the two converge. Beyond this point, MC will exceed MR, and producing more will reduce profit. Hence, the optimum is found at the precise balance point.

This principle is not only applicable in theory but also forms the basis for many applied decisions. In industries such as manufacturing, retail, or services, managers often monitor costs per unit and revenues per unit to decide whether to expand operations. Though in reality it may be difficult to measure marginal revenue and marginal cost exactly, the concept provides a benchmark for rational decision-making. Firms that consistently expand output when marginal revenue exceeds marginal cost and reduce output when marginal cost exceeds marginal revenue are effectively behaving in a way that brings them closer to profit maximisation.

The importance of this framework is reinforced by the assumption that firms seek to survive and grow in competitive environments. Profit provides the resources to reinvest in new technology, expand into new markets, or weather economic downturns. A firm that fails to maximise profit may find itself outcompeted by rivals that operate more efficiently. Profit maximisation therefore serves not only the immediate interest of the firm but also its long-term sustainability.

This second diagram illustrates the same idea from a different angle. Total revenue starts at zero and rises as more output is sold, though it eventually flattens as demand constraints limit sales. Total cost also starts at zero but rises with output, initially more slowly and later more steeply as marginal costs increase. The difference between these two curves represents profit. The maximum profit is achieved at the point where the vertical distance between the revenue and cost curves is greatest, which corresponds to the same output level where MR = MC.

From this analysis, we can conclude that profit maximisation provides a clear rule and a logical method for determining output. It is the benchmark against which other objectives of business can be compared. Later sections will show that firms may also pursue other aims, such as sales maximisation, growth, or social objectives. However, profit maximisation remains central in economic theory because it aligns with the rational pursuit of efficiency and survival in competitive markets.

The Principal–Agent Problem

In many firms, particularly those that are large and complex, the decision-making structure is not straightforward. When a firm is small and owned directly by its operator, such as a sole trader or family business, the person who owns the business is the same person who manages it. In this case, the interests of ownership and control are perfectly aligned, and there is no conflict. The owner wants the business to succeed, and the decisions taken directly reflect this aim.

However, as firms grow larger, especially in the case of public limited companies, ownership and control often become separated. Shares in such firms are held by a wide group of individuals, known as shareholders, who act as the principals. They are the legal owners of the company and are entitled to the profits in the form of dividends, but they do not themselves manage the day-to-day running of the firm. Instead, they appoint professional managers, known as the agents, to act on their behalf. These managers make operational decisions, set strategic direction, and are responsible for implementing policies.

The principal–agent problem arises when there is a conflict between the objectives of the principals (the shareholders) and the agents (the managers). In theory, managers are expected to act in the interests of shareholders, maximising profits and ensuring that the firm delivers strong returns. However, in practice, managers may have their own objectives, which may not perfectly align with those of the owners. For instance, managers might prefer to increase their own salaries, expand the size of the firm to boost their prestige, or pursue personal goals such as reducing their workload.

This conflict is exacerbated by the problem of asymmetric information. Managers are directly involved in the operation of the firm, and they typically know far more about the firm’s activities, costs, and prospects than the dispersed group of shareholders. Shareholders, being outsiders, cannot easily monitor all of the decisions managers make. Because of this imbalance, managers are able to make decisions that may serve their own interests without the shareholders immediately realizing.

For example, suppose the shareholders wish for the firm to maximise profits so that dividends are high. Managers, however, might decide to devote resources to perks such as luxury offices, corporate cars, or other benefits that enhance their own lifestyles but do not improve profits. Alternatively, managers might pursue expansion into new markets not because it maximises shareholder value, but because it increases the size of the company they control, giving them more influence and status. In these situations, the agents’ interests diverge from those of the principals, creating inefficiency and reducing the firm’s profitability.

The seriousness of the principal–agent problem depends on the strength of accountability mechanisms. If shareholders can closely monitor and discipline managers, then the managers have strong incentives to act in line with shareholder goals. For example, if managers are rewarded through performance-related pay linked to profits, their objectives may be realigned with those of the shareholders. Conversely, if shareholders are weakly organised and dispersed, managers may enjoy considerable freedom and may prioritise their own objectives with little consequence.

This problem is particularly significant in modern economies where ownership of large companies is widely dispersed. Individual shareholders typically own only small stakes and therefore have limited power to directly influence management decisions. In such cases, shareholders may rely on institutions such as pension funds or investment trusts to represent their interests, but even these institutional investors face challenges in monitoring complex organisations.

From an economic perspective, the principal–agent problem represents a divorce of ownership from control. While the owners hold the residual claim to profits, the actual control over resources lies with managers, whose incentives may not be perfectly aligned. This separation introduces inefficiency into the system, as firms may not operate at the point of maximum profit. Instead, resources may be diverted to satisfy the private aims of managers, which may include job security, personal comfort, or the desire to expand the firm for prestige rather than profit.

It is important to recognise that the principal–agent problem is not inevitable in all circumstances. If managers fully share the aims of the owners, there will be no conflict. For example, in closely held firms where managers also own large stakes, they have every reason to maximise profits, since they directly benefit from higher dividends and rising share values. The problem arises most strongly where there is a clear division between ownership and management and where shareholders are too dispersed or uninformed to enforce their preferences effectively.

The presence of the principal–agent problem complicates the analysis of firm behaviour. If firms are not always managed with the single objective of maximising profit, then outcomes in terms of output, pricing, and efficiency may differ from what traditional theory predicts. This makes it important for economists to consider the incentives of managers as well as those of shareholders when analysing business objectives.

X-inefficiency

Economic theory often assumes that firms always operate at their lowest possible cost for any given level of output. This would mean that at each output level, the firm is producing on its long-run average cost curve, so that resources are used in the most efficient way possible. However, in practice, firms may not always achieve this outcome. When managers lack strong accountability, they may allow inefficiency to creep into the firm’s operations. This is referred to as X-inefficiency.

X-inefficiency occurs when a firm is not operating at the minimum cost that is technically achievable with the resources it has. Instead, the firm operates at a higher average cost than necessary because of organisational slack. This slack may take many forms, such as poorly motivated employees, wasteful use of resources, or inadequate control of expenditure.

In this diagram, the LAC represents the minimum achievable cost at each level of output. The firm, however, is shown producing at q₁ but at an average cost of AC₁, which lies above the efficient cost on the curve. This vertical gap between the actual cost and the lowest possible cost at q₁ represents the extent of X-inefficiency.

The causes of X-inefficiency are often linked to the principal–agent problem. If managers are not tightly monitored by shareholders, they may not take every step to minimise costs. They might allow unnecessary expenditures, such as overly comfortable working environments, or fail to enforce strict productivity standards. Managers themselves may be motivated by personal convenience or a desire to avoid difficult decisions, rather than by profit maximisation.

The existence of X-inefficiency means that firms can operate with costs that are higher than they need to be, even though technically it would be possible to produce at lower costs. This undermines the assumption of traditional economic analysis that firms always lie on their cost curves. Recognising X-inefficiency, therefore, adds realism to the study of business behaviour, as it highlights how imperfect incentives and weak accountability can lead to waste and reduced competitiveness.

Other maximisation objectives

Although profit maximisation has often been seen as the primary objective of firms, in practice, managers may pursue a range of alternative goals. These can include sales revenue maximisation, growth maximisation, and long-run survival. Each of these objectives reflects the fact that managers may have motivations that differ from those of owners, particularly where the principal–agent problem is significant.

Sales revenue maximisation

The economist William Baumol developed the theory that managers may aim to maximise sales revenue rather than profit. This can happen because managerial salaries, bonuses, or prestige are often tied to the size of the firm, which is measured by revenue rather than profit. For example, managers may feel more secure in their positions if the firm has a high turnover, since large firms are often harder to take over and are more visible in the market.

In this framework, the firm’s total revenue is maximised at the point where marginal revenue falls to zero. This is to the right of the profit-maximising output, which occurs where MR = MC. Thus, a revenue-maximising firm produces more output than a profit-maximising one. Although profits may be lower, the firm still earns some level of return, and managers may be satisfied with this outcome.

Sales revenue maximisation may be constrained by the need to earn at least a minimum profit to satisfy shareholders. This means that managers cannot expand output indefinitely; they must ensure that profits do not fall below a level acceptable to the owners. Nevertheless, within this constraint, managers may prefer higher output and sales revenue, because these bring personal benefits such as prestige, influence, and job security.

Growth maximisation

Another common objective is the pursuit of growth. Many large firms in modern economies seek to expand their scale of operation, market share, and global presence. Growth can provide many advantages, including economies of scale, increased market power, and the ability to deter rivals. A growing firm can reinvest profits to fuel further expansion, and growth itself may enhance the reputation of managers and employees alike.

Growth can occur organically, through the reinvestment of retained earnings, or externally, through mergers and acquisitions. Organic growth may involve expanding product lines, entering new markets, or scaling up production capacity. Mergers and acquisitions allow firms to achieve sudden increases in size, although they can also create challenges in terms of integration and cultural differences.

From a managerial perspective, growth can also serve as a defensive strategy. A firm that is large relative to its competitors may be more secure against takeover bids. Managers may therefore pursue growth not only to increase shareholder value but also to protect their own positions and enhance their influence.

Utility maximisation

Some economists, such as Oliver Williamson, have suggested that managers may seek to maximise their own utility rather than strictly focusing on profit. Utility in this context refers to the personal satisfaction managers derive from their roles. This can come from higher salaries, greater job security, enhanced status, or discretion over how resources are used.

For instance, managers may gain utility from having a large team of subordinates, a prestigious office, or a generous expense account. These objectives may not maximise shareholder profits but do provide satisfaction to managers themselves. In such cases, the firm’s behaviour reflects the personal goals of agents rather than the strict financial interests of principals.

Long-run profit maximisation

Although short-run profit maximisation is often emphasised, some firms may take a longer-term perspective. Managers may decide to sacrifice short-run profits in order to secure higher profits in the future. For example, they might invest heavily in research and development, accept lower margins while establishing a new product, or delay price increases to maintain customer loyalty.

This approach reflects the recognition that long-run success sometimes requires patience and investment. By keeping prices stable, firms may protect their brand reputation and deter entry by rivals. Similarly, investing in technology may initially reduce profits but eventually lower costs and raise productivity. Long-run profit maximisation therefore differs from the simple short-run MR = MC condition by incorporating strategic choices that pay off over time.

Non-maximisation objectives

Although traditional economic analysis has assumed that firms always act rationally to maximise profits, in reality, firms may not always behave this way. There are several reasons why profit maximisation may not be the dominant objective. Managers may lack the ability to collect or interpret all the information necessary to maximise profit, they may face constraints from shareholders, or they may pursue other social or personal goals. These alternative objectives are grouped together as non-maximisation objectives. They provide a richer and more realistic understanding of how firms behave in practice.

Bounded rationality

The concept of bounded rationality was developed by Herbert Simon to explain why firms may not achieve fully rational outcomes. In theory, rational behaviour would mean that firms gather all relevant information about costs, revenues, and market conditions, and then process this information to select the precise output level that maximises profit. In reality, this is often not possible.

Firms may lack the capacity to acquire all the necessary data, or the cost of obtaining and processing the information may be too high. Market conditions may be uncertain, with rapid changes in technology or consumer demand making it impossible to forecast perfectly. Managers may also lack the analytical ability to interpret complex data. As a result, firms operate under bounded rationality: they do their best with the limited information and resources available but cannot achieve the fully rational profit-maximising outcome assumed by traditional models.

Bounded rationality does not mean firms behave randomly. Instead, it means they adopt rules of thumb, make decisions based on partial information, or aim for satisfactory outcomes rather than optimal ones. This limitation explains why actual firm behaviour may deviate from the predictions of strict economic theory.

Profit satisficing

Profit satisficing is closely related to bounded rationality but highlights the role of managerial motivations. Rather than seeking to maximise profit at all costs, managers may aim to achieve a level of profit that is simply sufficient to satisfy shareholders and keep them supportive, while pursuing other objectives alongside.

For example, managers may prefer a quieter life, avoiding the pressure of pushing output and efficiency to the absolute maximum. They may be content with producing a “good enough” return that keeps shareholders from intervening. Once this minimum target has been met, managers may devote attention to their own interests, such as enjoying more leisure, creating a more comfortable working environment, or expanding their personal influence within the firm.

Profit satisficing behaviour arises because managers are agents rather than owners. Their utility may not be maximised by driving profits to the highest level but by striking a balance between meeting shareholder expectations and securing their own comfort and job satisfaction. Economists describe this as “satisficing” behaviour: producing just enough profit to satisfy external stakeholders but not striving for maximisation.

Social welfare

Some firms may not be driven by profit at all, especially in the case of non-profit organisations, charities, or enterprises that prioritise social goals. These firms may aim to improve community welfare, provide services to disadvantaged groups, or pursue environmental sustainability.

For such organisations, profit is not the ultimate goal but rather a means to sustain operations. They may still need to cover costs and generate surpluses to reinvest, but their overriding objective is to deliver social benefits rather than shareholder returns. This shows that not all economic organisations fit into the profit-maximisation framework. Some explicitly adopt welfare-oriented missions, altering their behaviour in terms of pricing, output, and resource allocation.

Corporate social responsibility

In recent years, even profit-making firms have increasingly embraced the idea of corporate social responsibility (CSR). This involves demonstrating a commitment to ethical behaviour, environmental stewardship, and social contribution, beyond the narrow goal of maximising profits. Firms may engage in activities such as reducing carbon emissions, supporting community programmes, or improving the welfare of their employees.

CSR is not purely altruistic. In many industries, engaging in CSR has become essential for maintaining a strong reputation and securing customer loyalty. Consumers are increasingly conscious of how products are produced and the broader impact of firms on society. A company perceived to neglect social responsibility may suffer reputational damage, which could reduce sales and profits. In contrast, firms that actively promote CSR may enhance their brand image and gain a competitive advantage.

This means CSR can be viewed as part of a firm’s long-term strategy to safeguard market position. While it may involve immediate costs, it can protect profitability in the long run by ensuring customer trust and regulatory approval. In this sense, CSR represents both a non-maximisation objective and a strategic adaptation to modern competitive environments.

Evaluation of objectives

The discussion of different objectives reveals that firms do not always pursue a single, clear aim. In theory, profit maximisation provides a precise rule, MR = MC, for determining the level of output that yields the highest return. This traditional model is useful because it gives economists a benchmark against which other behaviours can be assessed. However, when we look at real-world firms, a more complex picture emerges.

The first complication comes from the principal–agent problem. Shareholders, as owners, want profit maximisation. Managers, as agents, may pursue objectives that give them personal utility, such as sales maximisation, growth, or prestige. These aims can diverge from the interests of shareholders. Unless owners can tightly monitor managers, the separation of ownership and control creates scope for alternative goals to be pursued.

The second complication arises from bounded rationality. Even if managers wanted to maximise profit, they might not be able to do so in practice. Limited information, changing markets, and cognitive constraints mean that firms often settle for satisficing behaviour, reaching adequate rather than optimal profit levels. This realistic constraint on decision-making explains why the neat predictions of the MR = MC model are not always observed in practice.

Another consideration is the time horizon of firms. In the short run, profit maximisation may mean charging higher prices or cutting costs aggressively. In the long run, however, such strategies may damage brand loyalty, employee morale, or customer trust. Some firms, therefore, deliberately accept lower short-run profits to secure higher long-run gains. For example, they may invest in research and development, build relationships with consumers, or demonstrate corporate social responsibility to protect their reputation. These long-term strategies can be rational, even though they depart from the immediate profit-maximisation rule.

Furthermore, not all firms are structured as profit-driven organisations. Some charities and social enterprises operate with explicit social welfare goals. The assumption of profit maximisation cannot capture their objectives, yet they still play an important role in the economy. Even profit-making firms may be influenced by social pressures, regulations, and cultural expectations that lead them to adopt non-financial objectives such as environmental sustainability.

When we evaluate the objectives of a business as a whole, it is clear that the traditional focus on profit maximisation remains central in economic theory because it provides clarity and rigour. At the same time, incorporating the principal–agent problem, bounded rationality, satisficing, and CSR gives us a richer understanding of firm behaviour. Modern economic analysis, therefore, recognises that firms may have multiple objectives, shaped by both internal motivations and external pressures.

Efficiency revisited

Having considered the different objectives of firms, it is essential to link these back to the concept of efficiency. Efficiency in economics refers to the use of resources in a way that maximises the benefits to society. It can be analysed in several dimensions: productive efficiency, allocative efficiency, dynamic efficiency, and X-efficiency.

Productive efficiency occurs when a firm produces at the lowest possible average cost, so that resources are not wasted. In diagrammatic terms, this means producing at the minimum point of the average cost curve. If managers allow X-inefficiency, then the firm operates above this point, meaning resources are not being used as efficiently as possible.

Allocative efficiency occurs when the price charged to consumers equals the marginal cost of production, so that resources are allocated to the goods and services most valued by society. In competitive markets, this condition tends to be met. However, in monopoly or other imperfect markets, firms set prices above marginal cost, leading to under-consumption and a welfare loss.

Dynamic efficiency refers to efficiency over time. It reflects the ability of firms to innovate, invest, and adapt to new technologies. Profit maximisation can promote dynamic efficiency because firms with high profits can reinvest in research and development. On the other hand, if managers are satisficing or pursuing alternative objectives, they may under-invest, reducing innovation.

X-efficiency describes the degree to which firms minimise costs in practice. As discussed earlier, the principal–agent problem and weak accountability can lead to X-inefficiency, with firms operating inside their cost curves rather than on them.

By revisiting efficiency, we see how the objectives of business have wide implications for the performance of markets. If firms consistently aim to maximise profit and are held accountable by shareholders, they are more likely to achieve productive and dynamic efficiency, benefiting consumers through lower costs and innovation. If firms pursue alternative objectives without constraint, efficiency may be reduced, with higher costs, misallocation of resources, and lower innovation.

Thus, efficiency provides a critical lens through which to evaluate business objectives. The ultimate question is not only what firms aim to achieve, but how their objectives affect the overall performance of the economy and the welfare of society.