The neoclassical theory of the firm explains that firms are run entirely for the profit motive of its owners. This has been a widely held theory for many years, with the knowledge that all businesses are purely profit maximizing entities, whose intention is to make profit regardless of the circumstances, actions or omissions.
The profit motive assumption postulates that all actors in the business enterprise are driven by the need to increase their earnings from the business profits. The management wants to earn large pay and bonuses whereas the shareholders want to increase their value for their stocks.
Adam smith, regarded as one of the pioneers of the theory of the profit motive of the firm explained that firms exist primarily to make profit, and would compete with others for the market share so as to sustain its profitability. Modern business environment has however refined and defined business operations to mean that it’s not only the profit motive that drives the modern business today, although the issue of profit cannot be overlooked (Coase, 1937)..
Some of the arguments that are used to explain this shift in business ideology has to do with the growing involvement of the government in business operations as a regulatory body, growing consumer needs as well as participation in business as well as the ever growing need for the business to be a key player in activities of the society through corporate social responsibility, taking cognizance of the fact that a business does not exist in a vacuum.
The following reasons and arguments explain the reason why the neoclassical assumption of the profit motive may not reflect the reality of modern business enterprises.
While the primary motive of a business according to the classical theorists was to maximize profit, modern economists emphasize on the business need to be stable in its market. This, according to scholars has led to businesses pursuing the need of increasing their market share as opposed to profitability. You will see firms acquire loss making enterprises in their line of operations. This mainly with the aim of ensuring that they are the sole largest players, although ultimately, market share translates to profitability, normally, the initial motive is not to increase profits but to have the pride of being the largest market share owner. This is a motive, which various businesses have pursued in the past.
A desire to innovate
Many businesses, especially in the technology industry are driven by the desire to make new things and products and be noted in the global maps as the producer of such and such an item or product. Some business owners feel the need to keep on discovering new things, regardless of the profitability or otherwise of the given product. The need to be innovative, to engineer new products has for instance been one of the key energy in most technology companies such as Google, Microsoft and Apple, etc.
Most entrepreneurs who are driven by this urge usually have a passion for a particular thing, or process and would like to do that, regardless of the profit motive, as long as such innovation is beneficial to others.
The desire to compete
Some business owners actually go into their business just for the desire to compete, to feel bigger, stronger and even smarter. These entrepreneurs often do not consider the financial implication of their business, but are just in it for competition. They want to threaten others, to intimidate, and feel successful. This need to show that they are better, bigger and smarter keeps them going, and this clearly indicates that in modern business, profit motive may at times take a back seat. This is explained in the management discretion model by Williamson.
Sometimes, the management of a business, for instance the CEO could work really hard with the sole intention of building his or her legacy. Although at the helm of the company/business, the management’s key aim may be to leave a legacy as having been the best manager of the business during their time. This sort of motivation is sometimes so strong that managers make personal sacrifices to ensure that a business succeeds just for the sake of their legacy.
In order to fully critique the profit motive of the firm, it’s imperative that we explore the alternative business models that outline the fact that besides the profit motive, the business has several other motives, and profit motive may not always take centre stage, in the wake of these other competing motives. These are explained by the following models
Sales Maximization Model (Baumol)
According to the Baumol model, firms do not seek to maximize profits but rather revenue. The model explains several possible reasons for this and includes that the business may be aiming at growing or even sustaining her market share in the industry, or even trying to ensure survival.
Growing sales as opposed to profitability is used to discourage competition and most importantly new entrants in the market, which is of course good for business. This may also create some form of prestige to management who would be happy to be seen to be running a very large organization as opposed to a particularly profitable venture (Putterman, 1996).
This is a very interesting business model that postulates that the business has many interested parties such as management, employees, owners, shareholders, customers, government etc. The business objective must therefore be to meet the needs and expectations of all these stakeholders, some of which are even conflicting, In so doing, the business will have to settle for profits that are lesser than what would be the case in a purely profit maximizing entity. The consensus model is therefore a great shift from the profit maximizing entity that would make highest profits disregarding the interests of other stakeholders.
Wealth Maximization Model
According to this theory which is drawn from corporate finance, businesses should attempt to maximize shareholders wealth and not profitability. Wealth, in finance is the value of the shares in a company. This means that the business will not be interested in making profits, but rather investing in ventures that maximize the value of the shareholders wealth even though they do not result to immediate profitability (Goodwin et al, 2010).
Business Ethics, corporate governance and corporate fraud
The term corporate fraud resulted from the orthodox means that businesses use to make profits while disregarding the plight of other stakeholders. For instance, a business could use the wrong measurements, intentionally in order to gain undue advantage of their customers. Secondly, a business would go a long way in ensuring non disclosure of financial information so as to reduce their tax liability.
Use of unethical business practices such as unfair competitive practices has also been cited as some of the things that businesses engage in their quest to fulfill the profit motive. A closer look at businesses today reveals that there is greater emphasis on good corporate governance, fair and ethical business practices as well as avoidance of any activity that would lead to a bad corporate reputation.
The governments of today have put in measures that are contained in various legislations that ensure that regardless of the motive of the business, the business engages in a practice that is fair and ethical and considerate to the stakeholders. Fines and penalties are in store for a business that engages in corporate malpractices. At the extremes, a business sometimes risk deregistration if caught in activities that have far reaching impact on the interests of other stakeholders.
Besides this, a business that is sensitive to the plight of its environment and contributes towards the social development and economic growth of the society in which it operates is likely to be stable in the long run. The realizations of these facts have led the modern business enterprises to seek to contribute as well as partner with the local society so as to drive the agenda of the society. This obviously sharply contrasts with the capitalist and cut throat profit motive of neoclassical model business enterprises (Pindyck,2010)
Appropriateness of the profit motive
Having explored the criticism of the profit motive of the firm, we now explore the circumstances under which the profit motive is appropriate. Looking at a business life cycle, one notes that during the maturity stage, the business is not expected to grow any further, and in fact the next stage is decline. At this particular stage of the business lifecycle, it’s quite appropriate that the company insists on returns in terms of profits (Pindyck,2010)
While it may not be applicable in the purely profit motive of the neoclassical theory of the firm, the business strategy should be to maximize on profitability, and minimize costs so as to ensure that by the time the company is exiting them market, the owners have made a significant return off their investment, and this is one critical stage when the profit maximization motive is expected.
In a monopoly, a company has absolute or relatively absolute market share, with little or no competition or threat to entry. At this time, regardless of what the business engages in, as long as it’s ethical, the pure profit motive is admissible. This is because, the business is guaranteed of a market, regardless of the dynamics and therefore, following a purely profit motive may be excused, even tolerated as consumers have little choice.
The neoclassical business model of pure profit motive was well intended to benefit the owners of the business. In fact, the profit motive still seats deeply at the heart of every organization, and in fact, even all the other motives that we have discussed above point at profitability, or at least something akin to that. Therefore, while we critique the motive, it’s important that we understand its importance and relevance to the business and commerce.
The pursuit of this motive however, should not overshadow other worthy and well intended actions of the organization. In an environment where all stakeholders in the business are keen to see how a business conducts itself and reward or punish unbecoming business behavior, it’s imperative that all business owners and managers appreciate that besides the core profit motive, the modern business needs to recognize that the expanded stakeholder’s needs are also important and cannot be ignored.
Pindyck, R. S.; and Daniel L. (2010). Microeconomics. Prentice Hall,
Goodwin et al (2010) Microeconomics in context 2nd Ed , new Delhi. India
Coase, R.H. (1937). "The Nature of the Firm". Economica 4 (16): 386–405
Thomas N. H. (2008). "firm boundaries (empirical studies)," The New Palgrave Dictionary of Economics, 2nd Edition.
Putterman, L. (1996). The Economic Nature of the Firm. Cambridge: Cambridge University Press. ISBN 0-521-47092-7.
Spulber, D. F. (2009). The Theory of the Firm, Cambridge.