Sunday, May 19, 2013

ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 4 – “The myth of profit maximization”

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Maximize profits or minimize losses?: the problem of risk

The problem of uncertainty we have just analyzed inevitably leads us to consider another important business decision problem: the problem of risk. This essentially means that entrepreneurs, by always acting under conditions of uncertainty, are constantly faced with the possibility that their actions do not achieve the expected results. In other words, their decisions always involve risk.

The consequences of this for the orthodox model of business rationality are truly destructive because, in conditions of risk, the rationality of businessman will consist more on ensuring a minimum level of profits or minimize losses than in maximize profits. And this for three reasons:

First, by the direct relationship between benefit and risk. Entrepreneur are well aware that if they want more benefits will have to take greater risks. Therefore, seek maximum profits would imply also assume the greatest risks. But because practically no one wants to do that we will have that entrepreneur do not necessarily be governed by the maximum possible but rather will accept a net income in accordance with the conditions (think in the cases of economic crisis). There is no reason, therefore, to believe that the entrepreneur has to act in a position of maximum, that is only a theoretical possibility.

Second, due to the stability that businesses require to plan. In effect, every company needs to maintain a minimum level of income to carry out their plans. Otherwise, if you search always maximum profit, the company may end up having a level of profit too fluctuating and therefore, it will be extremely difficult to make long-term plans due to financial uncertainty. So not only must take into consideration the profit but also the stability and security. That's why Japanese economist Shigeto Tsuru, after reviewing several cases of real companies, refers that: “It became clear that the determinant essential criterion of the behavior of the company was rather that of stabilize the benefit for a period of time long enough. Even more recently, it has been suggested an amendment in the sense that the goal of the companies should target to “maintain position of stability for a long period”. In other words, it means that in the description of the behavior of the company, the term maximization of security is more accurate than the term maximization of profit” (1).

Third, because the managers are more punished for incurring losses than rewarded for make profit. Effectively, given the context of separation between management and ownership, managers are more interested in avoiding losses than in achieve the maximum profit. Why? Because while managers and executives do not receive the benefits that may result from assume higher risks (shareholders take these), they may be dismissed if incur significant losses. Therefore, they will seek carry out their work efficiently obtaining for shareholders an acceptable profit level, but not necessarily will seek the maximum profit because this could also endanger their own job security.

Thus, if, as often happens, the maximization of profits increases the risk of losses, the manager will not accept the bet for basic considerations of interest. And more even if it is a large company with market power. It's no wonder that Paul Samuelson himself accepts that “as the company gets to have significant size and to have some control of prices, it can afford to loosen up a bit in its maximizer activity” (2). Or that the orthodox economist Carl Kaysen says: “While in the very competitive market the company has no choice but to seek maximum benefits, because the alternative to it is a insufficient benefit to ensure the survival, in the less competitive market the company can choose between seeking maximum profits or conform with a profit “aceptable” and pursue other goals” (3).


1) Shigeto Tsuru, “¿Ha cambiado el capitalismo?”, in: ¿A dónde va el capitalismo?”, Oikos Press, Barcelona, 1967, p. 47
2) Paul Samuelson, Economics, McGraw-Hill, New York, 1976, p. 508.
3) Carl Kaysen, “The Corporation: How much power? What scope?”, in: The Corporation in Modern Society, Edward S. Mason ed., Harvard University Press, Cambridge, 1959, p. 90.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and (email)