Do firms maximize profits?
First clarification I want to make is the understanding that this post isn’t about whether firms should or not maximize profit – which can just as well be the theme for another post. Most Micro and Macroeconomic Theory start from the premise that each firm seeks to maximize profit, which is intuitively sound and can be shown under some polar assumptions: e.g. If each firm is owned by different owners or if all portfolios in an economy are perfectly diversified. This isn’t terrible as an assumption for an economic model, since it must be a simplified representation of reality. However, on our attempt to get to know the world through Economic lenses, we shall not feel comfortable in dealing with a semi-reasonable assumption as a substitute for reality.
Some recent Industrial Organization (which is the field of Microeconomics that deals with market structures and the firm as it is and not necessarily by what it does) papers focus on answering this question that seems deceivingly simple. Understanding what a firm is trying to do is an effort to comprehend the incentives behind the decision making process of firms as economic agents, which is of utmost importance. Two main issues have being raised regarding the profit maximization assumption is Corporate Governance/Principal-Agent Problem and the Portfolios which own shares in different firms in the same market.
The first issue reflects the problem that a firm’s owners aren’t necessarily (and often aren’t) the ones making the decisions. Thus, even if the incentives for owners would be coherent with profit maximization, the CEO’s incentives and from every employee down the chain may not be, so chances are it isn’t those the real incentives behind the daily decision making process. One way to “deal” with this in economic models is by weighing in the profit function with some type of corporate governance index.
The second issue shows something that is often hidden even from antitrust authorities. It is known that horizontal mergers (i.e. Merger of natural competitors) reduces Competition and often raises prices and reduces output. Thus, most countries have structured institutions and guidelines to defer whether a merger isn’t or not in the best interest of society. However, much of the investment in firms nowadays is given through the stock markets and it isn’t uncommon for investors to own shares of natural competitors, and thus to want some collusion among the firms to maximize their joint and not individual profit. Of course much of this isn’t more than wishful thinking since each investor tends to be small given the size of the market. But since reality isn’t that of perfect diversification of portfolios, it also can’t be ignored.
There is still a long way to decipher the true payoff taken into account on different firms on their decision making process, and that is a journey I am happy to dedicate my professional life in pursuing.