Theory of Profit Maximization

Traditional theory assumes profit maximization as the only objective pursued by the firm. It further assumes that the firm strives towards this goal rationally, i.e., it has perfect knowledge of relevant decision making variables. The firm has complete information of the size of the firm, product and factors, and also about market demand, supply and prices.

The conventional theory regards a firm as an organization that transforms inputs into output to create 'surplus value' or profit. Profit maximization forms the basis of the conventional price theory. It explains the behaviour of price and output decisions of a firm under different market structures as, well as predicts- the behaviour of firms in real world.

Originally, the theory of firm was based on the assumption that the goal or objective of the firm was to maximise current or short-term profits. Firms however are often observed to sacrifice short-term profits for the sake of increasing long­term profits. For instance expenditure on research and development new capital equipment and major marketing programmes is undertaken to increase profits in future.

Since both short-term and long-term profits are important it is- assumed that the primary objective of the firm is to maximise the present or discounted value of all future profits, i.e., 'value of the firm. Future profits must be discounted to present because a rupee of profit in future is worth less than a rupee of profit today. Formally stated the value of the firm or wealth is given by 

where PV is the present value of all expected profits of the firm, p₁,p₂ .. is the expected. Profits in each of the n. years considered, and r is the appropriate discount rate used to find the present value of future profits. The Greek letter L indicates the sum of and t refers to values from 1 up to the n years considered.

The present value of all future profits also can be interpreted as the value of the firm. That is, it is what a willing buyer would-pay for the business. Thus, to maximize the discounted value of all future profits is equivalent to maximizing the value of the firm. 

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