San José State University|
Department of Economics
& Tornado Alley
the Proper Objective
for Firms in a Market Economy?
The answer to this question is that while profit maximization expresses the general nature of the objective of firms it is not profit per se that firms should try to maximize. Instead firms want to maximize the value of their equity holdings. This equity value is equal to the expected (discounted) present value of the net returns from those holdings. Returns is used here rather than profit because of some technicalities which will dealt with later. The most important clarification required is the matter of equity based upon long term considerations versus the short term concept of profit.
If the firm is operating in a steady state condition such that all conditions are constant over time then, and only then, will the maximization of annual returns be equivalent to the maximization of the present value of all net returns.
Even in the case of the steady state operation of the firm it is not profit per se which is the proper objective of the firm. The relevant profit for a firm is of course the profit after taxes. The tax bill for a firm depends upon the definition of taxable profit. In the U.S. and in most if not all modern industrial countries firms are allowed to deduct depreciation from their profit for tax purposes. This is appropriate in that depreciation represents the cost of capital used up in business operations. But depreciation deducted for tax purposes does not leave the firm so the total return to the firm is after-tax profit plus depreciation. Although this sum of after-tax profit plus depreciation might be characterized as true profit that is not the term used for it. Instead after-tax profit plus depreciation is called cash flow.
A firm's objective is therefore the maximization of the expected present value of cash flow net of the investment outlays that must be made to generate those cash flows. The quantity cash flow minus investment outlay might be dubbed true cash flow but the term used instead is free cash flow. Thus the firm's objective is the maximization of the expected present value of free cash flow. This expression does not quite have the same emotional impact of profit maximization even though it means essentially the same thing.
There may be some consequences of a firm's performance that do not, at least not immediately, show up in terms of free cash flows. For example, in the manufacture of complex products such as aircraft there is the phenomenon of the learning curve; i.e., the first unit is more expensive to produce than later units because the knowledge and skills acquired in producing the first unit are utilized in reducing the production cost for later units. In a sense, the benefit of producing the first unit is the explicit cash flow benefit plus the value of the knowledge and skills acquired.
Here is another example of benefits that do show up immediately in terms of free cash flow but are nevertheless benefits. In the 1960s under the government of Park Chung Hee in South Korea bids were solicited for the building of a bridge across the Han River in Seoul. The founder of Hyundai, Chung Ju Yung, offered to build the bridge for one Korean won, an insignificant amount worth less than one American cent. Hyundai got the contract and suffered a loss on the bridge but gained the attention and good will of the government which later led to lucrative government contracts.
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