1) ANS: Profit Maximization Objective of a Firm

Profit maximization is the most accurate description of managerial goal. The profit maximization is one
of the very important assumptions of economic theory, which always assumes that a firm aims to
maximize of profit. The attempt of an entrepreneur to maximize profit is regarded as a rational
behavior. Hence, profit maximization continues to be a central concept in managerial economics.
There are two approaches to explain the equilibrium of a firm on the context of profit maximization.
Among them one is old method of total cost and total revenue approach and another is the marginal
revenue and marginal cost approach.

Total Revenue (TR) – Total Cost (TC) Approach

Total revenue (TR) and total cost (TC) approach is the simplest method to determine the equilibrium of
a firm. To calculate the profit of a firm, we find out the difference between the  total revenue
and total cost at difference levels of output. A firm is said to be in equilibrium when the difference
between total revenue (TR) and total cost (TC) is maximum. Every rational producer will try to
maximize his profit. We can find equilibrium of a firm with the help of this approach both under
perfect and imperfect (monopoly) market competition.

i) Equilibrium of the firm under perfect competition

the firm is in equilibrium when it has no incentive to change its level of output. In perfect competition,
a firm is said to be in equilibrium when it maximizes its profits (π), which is defined as the difference
between total revenue and total cost.

π = TR – TC

Where, π = profit, TR = Total Revenue and TC = Total Cost

Given that the normal profit rate is included in the cost items of the firm, π is the profit above the
normal rate of return on capital and the remuneration for the risk bearing function of the
entrepreneur. The firm is in equilibrium when it produces the output that maximized the differences
between total receipts (Revenue) and total costs. The equilibrium of the firm can be explained with
the help of the following figure:
As shown in the figure, TR and TC are total revenue and total cost curves of a firm in a perfectly
competitive market. TR curve in a straight line through the origin, showing that the price is  constant at
all levels of output. The firm is a price taker and can sell any amount of output at the going market
price, with its TR increasing proportionately with its sales. The slope of TR curve is the MR. It
is constant and equal to the prevailing market price. Since all units are sold at the same price.

The slope of TC curves reflects ‘U’ shape of the AC curve i.e. law of variable proportions. The firm
maximizes its profit at the output ‘OX’, where the distance between TR and TC is the greatest. At the
lower (OX1) and higher levels (OX2) than OX, the firm has losses. The TR-TC approach awkward to use
when firms are combined together in the study of the industry.

ii) Equilibrium of the Firm under Imperfect Competition (Monopoly)  

Under imperfect competition, AR and MR of a firm are two different things. This is because under
imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In
the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for
a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost
and the marginal cost curve should cut the marginal revenue curve from below.

It is shown in the figure, at the beginning, total cost is higher than total revenue. There is no profit. At

points P and Q, total revenue is equal to total cost. So, there is neither profit nor loss and is called the
break-even point. After OA output, total revenue is higher than total cost, so profit begins to show. At
OB output, the difference between total revenue and total cost is maximum. The firm is in equilibrium
and earns maximum profit, TR - TC (EB - NB) = EN is profit. Point Q is again the break-even point.
Beyond OC output, total cost exceeds total revenue and the firm incurs losses. In case of perfect
competition, the TR become the straight line.

Marginal Revenue (MR) - Marginal Cost (MC) Approach

Marginal revenue and marginal cost approach is another method to know the equilibrium of a firm. The
modern economist Mrs. Joan Robinson propounded this approach. According to this approach, for a firm
to be equilibrium or maximization of profit, marginal revenue (MR) should be equal to marginal cost
(MC) and the marginal cost curve should - cut the marginal revenue curve from below. It will be
profitable for a firm to increase its production when MR exceeds MC.

i) Equilibrium of the firm under perfect competition

The equilibrium of a firm in the perfect competition can also be shown through the help of marginal
revenue (MR) and marginal cost (MC) approach. For fulfilling the condition of maximum profit, marginal
cost (MC) must be less than marginal revenue (MR). A firm is said to be in equilibrium when marginal
cost (MC) must be equal to the marginal revenue (MR) or MC curve must intersect MR curve from
below. It is shown in the figure:

In the figure, AR and MR are the same and AR=MR is a straight line. It is assumed that MC falls at first
and then starts rising. MC curve cuts MR curve at E point from below and it is equal to MR. The profit
maximizing output is OQ where firm fulfills two basic conditions of equilibrium.

ii) Equilibrium of a firm under imperfect competition (Monopoly)

Under imperfect competition, AR and MR of a firm are two different things. This is because under
imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In
the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for
a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost
and marginal cost curve should cut the marginal revenue curve from below.
In this figure, at point E both the conditions of equilibrium have been fulfilled. Hence, E is the point of
equilibrium. The firm gets equilibrium at OM output where marginal revenue is equal to marginal cost.
The OM quality of output is sold at price OP price. Before OM output, the increase in output add more
to revenue than to cost but after OM output, the increase in output adds more to cost than revenue.
Profit is the total revenue OMQP minus total cost OMNR. Hence, the firm earns the abnormal profit
equal to RNQP.

Criticisms/ Demerits of Profit Maximization Theory  The objective has been criticized by some
economists saying there may have other objectives in a firm such as sales maximization, welfare or
satisfactions etc. this objective is criticized on the following grounds.

1. Profit maximization criterion is vague and ambiguous. Profit may be long-term, after tax or
before tax. It is not clear.
2. In this objective, total profit earned during the life of assets and timing of their realization is
ignored. Hence, equal value for earning realized on different periods is not realistic. It ignores the time
value of money.
3. This objective is concerned only with the size of profit and gives no weight to the degree of
uncertainty of future profits. Two businesses with varying degree of risk and producing same size of
profit is considered similar under profit maximization criterion. Thus, the risk element is ignored,
which is one of the most important dimensions of financial management.
4. This objective is incomplete because it ignores the appreciation in the value of securities or
firm. Investors and owners of the businessmen are benefited not only by the earning of profit, but also
due to the appreciation in the stock price.

2) Ans: Factors Influencing Managerial Decisions

Managerial decision-making is the process of selecting a particular course of action from among a
number of alternatives. Since the factors of production are limited and can be put to alternative uses.
The objective of a firm is to achieve optimal result from use of available resources. If there were no
alternatives, there would be no scarcity, and no choice as well as no decisions, so that the problem of
choice arises.
The choice is the most important role of management. Hence, best choice should be made whether the
knowledge of future prospect, decision could be made and plans could be formulated without errors.
However in many cases, there may not complete knowledge. New decisions have to be made and old
plans may have to be repeated as new courses of action are adopted in order to obtain desired
objectives. The following factors influence the managerial decision-making.

1. Objectives of a firm: Efficient or optimal decision-making requires a goal or objective be

established. That is a management decision can only be evaluated against the goal that the firm is
attempting to achieve. Traditionally, economists have assumed the objective of the firm is to maximize
profit. That is, it is assumed that managers consistently make decisions in order to maximize profit.
That should be clear either in current year or in next year.
2. Economic factors: According to traditional concept a firm tries to maximize its profit. Many
economists have challenged this concept; the firm may have other objectives such as sales
maximization. Although it cannot be cleared that the preference for profitability is high. So that
manager should consider if the set course of action is profitable or not, can be done with least cost or
not. Demand forecasting, pricing condition, cost estimation will have to made for the purpose. It must
consider the size of and direction of future changes in prices, demand, general level of economic
activity, possible strikes, changes in fission, which affects the demand on the one side and on the
supply side. Cost of machine, cost of borrowing, cost of renting space to store would be studied.
3. Technological Factors: There is significant role of technology in decision making in the
economic theory. Technology also influences the business decisions. The manager must consider the
factor such as assessment and emerging new technological alternatives, the technological moves of
competitors and emerging new technological and process in their planning and available resource
allocation. The technological alternatives suitable to the situation should be taken as good for short
run marketing or production decision. But the consideration of technological factor cannot be
a basis for business decision with reaching at final decision, economic factor should also be considered
well.
4. Human and behavioral factors: The economic consideration is important in decision-making.
Although managers may not always give top most priority to economic consideration. It should be taken
into account the factors such as the impact of decision on employee’s morale (determination) as in
case of cutting of extra benefits of motivation. The small entrepreneurs may not be agreed to expand
or diversify despite green signals ahead because they feel that expansion may strain their quiet life or
may threaten their control over management. Manager must always consider constrain imposed upon
him by forces at work within his own firm such as individual and collective interests and pressures
within the firm. Hence, the manager should base his final decision on both economic logic as well as
human and personal thinking.
5. Environmental factors: The firm’s managers should be fully aware of the economic, social and
political conditions curtailing the country while making business decisions. The environment existing in
and out of the firm should be considered. The political and social consequences as to decision can’t be
overlooked. The importance of environmental factors is growing each day due to the following causes.
1. Public awareness: The awareness of the impact of firm’s decision on society is
growing. Many pressure groups like political parties, consumer’s forum, trade unions and other exist
these days. The pressure groups watch secondly the nature and consequences of a decision whether
decisions are harmful to their interest and they will protest the decision.
2. Social costs: The decision of firm has social through their productive activities like
pollution, congestion, development of slums and others. Hence, the manager may have to take into
account the environmental factors while making decisions. It should be considered carefully while
making decisions of all the factors. But economic factors still play a dominant role in decision making
because the firms are commercial in nature.
The managers cannot ignore the environment within which they operate. They must understand and
adjust to the external factors, such as government intervention in business, taxation, business cycle
fluctuation etc. Modern business has to keep itself well informed of changes in its environment and
adjust its decisions accordingly from time to time.
3) Ans

Managerial utility function maximizes the utility of the managers rather than profits of the firm.
The manager is expected to follow policies which maximize the following components of his
utility function.

I. Expansion of Staff: The manager will like to increase the quality and number of staff
reporting to him. This will lead to an increase in the salary of the staff. More staff are valued
because they lead to the manager getting more salary, more prestige and more security.

ii. Increase in Managerial Emoluments: Managerial Utility also depends on managerial

emoluments. It includes facilities like entertainment allowance, luxurious office, staff car,
company phone, etc. Expenditure of this nature reflects to a large extent the prestige, power and
status of the manager.

iii. Discretionary Power of Investment: Managerial utility also depends on the discretion of the
manager to undertake investment beyond those required for normal operations. The manager is
in a position to invest in advanced technology and modem plants. Such investments may or may
not be economically efficient. These investments may be undertaken for the self-satisfaction of
the manager.

According to the theory, in a firm, shareholders and managers are two separate groups. The firm
tries to get maximum returns on investment and get maximum profit, whereas managers try to
maximize profit in their satisfying function.

At last, Williamson’s managerial discretion theory shows the utility function of a manager. In
this theory, the firm will try to get maximum returns or maximum profit where as manager try to
maximum utility satisfying function. They are in equilibrium when the utility has maximum
amount.