Discuss the concepts of ‘Profit maximisation’ and ‘Wealth maximisation’ and analyse which concept is superior to be an objective of a Firm.
An enterprise manufactures and sells a definite amount of a commodity. The enterprise’s profit, denoted by π, is defined as the difference between its TR (total revenue) and TC (total cost of production). In other words,
π = TR – TC
The gap between TR and TC is the enterprise’s profits. An enterprise wishes to maximise its profit and likes to recognise the amount or quantity q0, at which its profits are maximum. By definition, at any quantity other than q0, the enterprise’s profits are less than q0. Here, the question is how do we recognise q0. For profits to be maximum, three conditions must hold at q0.
- The cost price p, must be equal to MC.
- The marginal cost must be non-decreasing at q0.
- For the enterprise to continue to manufacture in the short run, the cost price must be greater than the average variable cost (p > AVC), whereas in the long run, the cost price must be greater than the average cost (p > AC).
Profits are nothing but the difference between total revenue and total cost. Both TR and TC increase as the output increases. As long as the change in total revenue is greater than the change in total cost, the profits continue to rise. Recall that the change in TR per unit increase in the output is the marginal revenue, and the change in total cost per unit increase in the output is the marginal cost.
Now, let us consider the second condition that must hold good when the profit-maximising output degree is positive. Note that at output degrees q1 and q4, the market price is equivalent to the marginal cost. However, at output level q1, the marginal cost curve is a downward graph. We claim that q1 cannot be a profit-maximising output degree.
Let us consider the third condition that must hold good when the profit-maximising output degree is positive. Note that the third condition has two parts: one part is applicable in the short run while the other is applicable in the long run.
Wealth maximization is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company’s management team to continually search for the highest possible returns on funds invested in the business, while mitigating any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each prospective investment, as well as constant attention to the strategic direction of the organization.
The most direct evidence of wealth maximization is changes in the price of a company’s shares. For example, if a company spends funds to develop valuable new intellectual property, the investment community is likely to recognize the future positive cash flows associated with this new property by bidding up the price of the company’s shares. Similar reactions may occur if a business reports continuing increases in cash flow or profits.
Wealth Maximization considered superior to Profit Maximization
Although Profit and Wealth Maximization sound pretty similar, there are some major differences between them. While profit maximization aims at increasing the profit of a firm, wealth maximization has a larger role to play and it deals with the wellbeing of the stakeholders as a whole.
Profit Maximization Vs Wealth Maximization
Here are some major differences between profit maximization and wealth maximization in brief.
- Profit and wealth maximization deal in different subjects and hence they are defined differently. Profit maximization refers to the management of a firm’s resources and utilities to maximize profit. On the other hand, wealth maximization refers to managing the financial and managerial resources for the wellbeing of the stakeholder community as a whole.
Note − Wealth maximization plays a larger role in business than profit maximization.
- The main focus of profit maximization is on increasing the profit of the company while wealth maximization deals in raising the value of stakeholders in the company. The profit maximization theory is centered around the profit motive while wealth maximization looks at the wellbeing of all stakeholders.
- The risk and its effects on financials of the company are a core part of the wealth maximization process, while there is no focus on risk in the profit maximization theory. Therefore, in practice, profit maximization is not a complete theory in itself while wealth maximization is much more cohesive and inclusive in nature.
- Profit maximization is actually a concept that is basically related to day-to-day business profits. Wealth maximization is a more complex process of increasing the overall wealth of the company that is reflected in the increased price of shares in the market.
Note − Profit maximization does not cover the risk factors associated with finance and operations but wealth maximization does.
- Profit maximization is an older theory and hence it lacks the modern approaches towards business and profitability. Wealth maximization is a new concept that deals with a larger subject area and includes as many factors as possible. Therefore, wealth maximization is a better approach than profit maximization.
- Profit maximization was a very relevant theory during the early 19th century, while the wealth maximization concept is a newer concept in business. So, wealth maximization is more complex and inclusive in practice in general.
Note − Profit maximization is a theory of the past, while wealth maximization is a modern theory.