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posted on 03 January 2016

Do Firms Maximize Profits?

by Dirk Ehnts, Econoblog101

The Bank of England's report on the failure of HBOS has been published last month.

It is quite revealing:

The FCA/PRA Report documents particular, and dominating, cases of inappropriate risk taking, in the management of credit risk in the Corporate Division, the expansion overseas without regard to the risks involved, and funding the assets of the bank. The strategy of HBOS put the growth of the bank above these considerations until it was too late and impossible to change course. The last point here is important. The management of a firm is not required to have perfect foresight. The criticism in the Report is not that management failed to predict that there would be a global financial crisis. Rather, they should have put in place strategies that could in combination accommodate and respond to, in a timely way, changes in external circumstances. With these strategies firms can for example raise new capital or adjust their funding with the necessary confidence of success. HBOS lacked these strategies.

This goes against the usual microeconomics where it is assumed that firms maximize profits. The textbooks need to be rewritten. While HBOS is an outlier, nevertheless it is too-important-to-ignore. It is when things go wrong that we need economists to explain what happened. Commenting the failure of HBOS by saying that on average firm profits are zero and that profit maximization always maximizes welfare is just plain wrong.

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