About a year ago, we sat in the lecture room at the philosophy department at Wits. It was 10 am. Our professor always began the class by writing a question on the board and asking us to write a short essay about it. She gave us about 20 minutes, after which debate ensued. On one occasion, the question was, “Should businesses seek to maximise profit?”
The knee-jerk answer is yes. After all, without surplus value, a business cannot invest in future products and services, nor can it absorb unfavourable market conditions. In its simplest form: if you buy tomatoes to resell them, you do so to accrue residual value from which you make a living. In other words, you factor in the time it took to buy the stock, move it to a more convenient spot for your customer, and the administrative costs. The sale price therefore reflects all of this, plus a premium for taking the risk. Framed this way, a tomato bought for R1 can be sold for R1.50 — or is R10 also justifiable? That is the nub of the question.
Economists and philosophers have debated this topic for years, albeit on different grounds. Suppose you bought tomatoes for R1 and sold them for R1.50. In each transaction, your business would make a 50c profit, and it would make sense to increase sales volumes. However, the more units sold, the more complicated the business would become. It would incur greater transport costs, payroll, and spoilage, and it would attract competitors. At the same time, it would gain other advantages, like buying power and reputation, which reduce marginal costs and affect demand respectively. The CEO’s role would be to work out the number of tomatoes to sell at a given price point without incurring a marginal loss. This is profit maximisation.
The technical terms used are marginal revenue (MR) and marginal cost (MC). Marginal refers to the changes in cost/revenue for tomatoes sold at quantity A vs quantity B. That is to say, what conditions necessitate selling 1 million tomatoes per day compared to 10? And at what point on that continuum does it no longer make sense to sell more, i.e. at what point is profit maximised? Economists say that point is where MR = MC. Framed this way, in a competitive market, businesses should aim to maximise profit.
By way of example, is Apple profit-maximal? The answer is complicated, but we could make a better guess if we narrowed the question down to its iPhones. I would say yes because we know that Apple’s constraints are likely on the demand rather than the supply side. It could produce more iPhones at a relatively similar marginal cost. However, to sell them, it would have to choose a lower price point because people are unwilling or unable to pay. Since Apple has market power, it has chosen to maximise profit at relatively lower volumes and higher prices. In other words, it has determined not to produce more phones even though it can at a similar marginal cost.
What does all this mean for practitioners? In 2013, Uber launched in South Africa. The drivers who pounced on the opportunity early made good money. Some introduced additional cars and paid them off quickly. Over time, more and more drivers joined Uber and competition rose. Taxi associations protested and burnt vehicles, making it hard to operate. Meanwhile, Uber phased out older vehicles to maintain its standards and to create room for its own vehicles, which it rents out to drivers at a premium of approximately R3,000 per week. More recently, fuel prices have increased, and roads in Johannesburg have worsened, further raising marginal costs for drivers. Uber also increased its commission to 40% on some occasions — significantly more than the 25% charged at the beginning.
In other words, in the beginning, the marginal revenue relative to marginal cost favoured drivers, which is why they correctly introduced more vehicles. At some point, however, profit maximisation was reached, and the tipping point went unnoticed. Today, I think marginal revenue has fallen below marginal cost (MR<MC), which is why they work longer hours for less. In other words, it is not only that it no longer makes sense to introduce an additional vehicle, but drivers should reduce their fleet and direct their resources elsewhere, and this applies to e-hailing services in general. Without the principles discussed, these decisions are left to a hunch; drivers picket at Uber’s offices for better rates, but overlook unfavourable underlying market conditions.
I used Uber as an example, not to undermine the drivers or to insinuate their incapacity. I ride Uber almost every day. I speak to the drivers, and they often share their plight.
The point is that profit maximisation is about looking beyond the present unit economics and examining potential market changes. Given these considerations, does it make sense to invest in more infrastructure to increase sales? Is it better to command a higher price point at lower volumes to buy patience in an uncertain future, as Apple did? Is it better to buy out or merge with other companies, as Sibanye-Stillwater did to extend its lease on life? Or is it better to exit and pivot to another market, as Jaguar has done since 2021?
All these questions weigh on CEOs and are often overlooked by smaller business operators to their peril. If answered incorrectly, hundreds and sometimes thousands of people lose their jobs. The upside is also true: leaders who carefully assess profit (and perhaps more accurately, profit potential), not to drool over the prospect of making more money, but to ascertain market conditions, often create prosperity for themselves and their stakeholders. This is what profit maximisation is about.
Until next week,
Vusi.
P.S. Many readers ask for my permission to share these articles with friends. The answer is an emphatic no! Do not share. Rather, keep these articles as a secret weapon to apply when needed. I joke. Please feel free to share.
