Profit maximization vs. wealth maximization
/What is Profit Maximization?
Profit maximization is the process by which a business arranges its prices and cost structure to achieve the highest possible profit. The central goal of the organization is to increase its profits. This is a short-term goal, since profits can be maximized to the detriment of customers, who may become annoyed at excessively high pricing, and take their business elsewhere over the long term. Nonetheless, profit maximization can be a critical goal to pursue when a business is operating in a highly competitive industry where product cycles are extremely short - in this environment, they have to generate as much profit right now as possible, since their next set of products may not be as successful as the current lineup.
What is Wealth Maximization?
Wealth maximization is the concept of increasing the value of a business in order to enhance the value of the shares held by its stockholders. This may involve additional investments in intellectual property, strategic positioning, and product branding, as well as managing the risk profile of the business. This is a longer-term goal than profit maximization, since it requires investing funds back in to the business to ensure that its value increases over time. It is quite likely that a business pursuing wealth maximization will generate fewer profits over the short term than one that is concentrating on profit maximization, since wealth maximization usually mandates that expenses be increased to enhance the value of the firm.
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Comparing Profit Maximization and Wealth Maximization
The essential difference between the maximization of profits and the maximization of wealth is that the profits focus is on short-term earnings, while the wealth focus is on increasing the overall value of the business entity over time. These differences are substantial, as noted below.
Planning Duration
Under profit maximization, the immediate increase of profits is paramount, so management may elect not to pay for discretionary expenses, such as advertising, research, and maintenance. Under wealth maximization, management always pays for these discretionary expenditures.
Risk Management
Under profit maximization, management minimizes expenditures, so it is less likely to pay for hedges that could reduce the organization's risk profile. A wealth-focused company would work on risk mitigation, so its risk of loss is reduced.
Pricing Strategy
When management wants to maximize profits, it prices products as high as possible in order to increase margins. A wealth-oriented company could do the reverse, electing to reduce prices in order to build market share over the long term.
Capacity Planning
A profit-oriented business will spend just enough on its productive capacity to handle the existing sales level and perhaps the short-term sales forecast. A wealth-oriented business will spend more heavily on capacity in order to meet its long-term sales projections.
It should be apparent from the preceding discussion that profit maximization is a strictly short-term approach to managing a business, which could be damaging over the long term. Wealth maximization focuses attention on the long term, requiring a larger investment and lower short-term profits, but with a long-term payoff that increases the value of the business.