Profit maximization is when a firm’s primary objective is to make the most amount of profit possible when trading within its market .The traditional theory of the firm is based on the assumption of short-run profit maximization (Sloman, 2004). But there is an alternative theory which assumes that managers aim to shift cost and revenue curves so as to maximise profits over a long period. Many believe that the long run profit maximization theory would be a good alternative to the short run theory, but realistically it is very difficult to test.
Profit maximizing is based on two assumptions; that owners are in control of the day-to-day management, and the main aim of the owners is for higher profit. Profit is maximised where marginal revenue equals marginal cost. Shareholders (principles) employ managers (agents) to act on behalf of them to run the day-to-day business. As it is the managers that run the firm and not shareholders a conflict of goals and targets may occur, ‘principal-agent problem’ which can drastically affect the outcome of profit maximization.
Explain profit satisficing.
Profit satisficing is when firms set themselves acceptable levels of profit. It is seen that owners of a firm are willing to achieve ‘satisfying’ profits rather than ‘maximizing’ profits. The main reason this objective is used by firms is for development purposes. For example, smaller firms may want to steadily increase their market share, they can do this by setting an achievable objective, such as, increasing sales. If successful, managers may be motivated to set higher objectives, therefore, by setting achievable targets firms are steadily progressing to accomplish their prime objective.
Examine what Baumol, Williamson and Marris have to say with respect to company objectives.
Sales Revenue Maximization
Baumol (1959) stated that there is a clear difference between managers and shareholders of firms. Firms who are manager-controlled often seek to maximize their sales revenue compared to shareholders who favor profit maximization. Baumol believes that wages earnt by managers, are related closely to sales revenue than profit revenue. This is because managers have more interest into sales as they are operating the day-to-day business of the firm than shareholders and want to sell as much as possible. Whereas, shareholders see that profit is more important as they want to feel that their investment has been for a good cause and to guarantee that they receive healthy dividends.
An alternative view was put forward by Williamson (1963), who built a model based on the concept of managerial satisfaction (Griffiths, A. & Wall, S. 2004). This would be achieved by using funds from sales revenue to increase staff levels and projects. Williamson believed the simplest way of building up extra capital was through an increase in sales revenue as an increase in profits would most likely by paid out to shareholders. In respect to this objective both Baumol and Williamson that sales revenue maximization is backed by managers, but in different ways.
Constrained Sales Revenue Maximization
Baumol and Williamson both found that shareholders can implement a constraint on the decisions of managers. For instance, shareholders may introduce a minimum profit constraint created to underpin the valuation of their shares. Maximum sales revenue is considered to appear well above the level of output which generates maximum profits. The diagram shows how output and price changes if the firm switched its objectives from profit to revenue maximisation.
The profit maximising price is P1 at output Q1 while the revenue maximising is P2 at Q2. Due to the change in objectives, consumer surplus and sales revenue maximisation increases as output is higher and price is lower.
Marris (1964) believes that owners and managers have a common goal, namely maximum growth of the firm (Griffiths, A. & Wall, S. 2004). Marris states that an increase in demand for a firm’s product is a manager’s prime objective, whereas, owners want capital growth in the value of the firm to increase personal wealth. The most important aspect of this objective is the retention ratio, which shows how much money is being retained compared to how much is distributed as profits. If profits are mostly distributed the firm has a low retention ratio, if there is a high retention ratio, profit can be used for investment and growth of the firm. For an acceptable retention ratio to be achieved there must be, ‘balanced growth’ between the growth rate of the firms demand and capital.
What other objectives might firms have beside profit maximization.
Objectives may not merely be to maximise profits as this may not suit the business’s needs individually to succeed within its market.
An objective that businesses may have is to concentrate on sales growth (growth maximization). This is to try to achieve as many sales as possible in order to survive. By concentrating on sales growth a business will in turn become larger and thus help them survive within the market. By implementing sales growth a business is likely to have a large consumer base and benefit from economies of scale, as higher demand will lead to cheaper manufacturing costs when purchasing; bulk buying.
A firm may have an objective to be price satisfiers and be happy to achieve a minimum acceptable profit target. This may be because they are small firm within their market and opt to accomplish several small targets to achieve their overall goal in the long run. A main reason for satisficing is that firms may not have the adequate resources and capital compared to large firms to achieve objectives in a shorter time scale.
Another objective is the contingency theory, it is when the firm matches its internal structure with its external environment. For example, if a new company is entering the market of an existing company, the existing company may change its objective from profit maximization to market share in order to remain in its market.
Explain the difference between primary and secondary objectives of firms.
In the case of perfect competition a firm’s primary objective will be to survive in its market as they are price takers and are in a market where their product is homogenous. This means their primary objective is necessary for them to continue operating successfully (short run objective), whereas, secondary objective is something a firm would like to do in the future e.g. expand, introduce new products, etc. Secondary objectives are what the firm would do to further make them successful (long run objective) but may not be implemented until later due to a lack of resources or not accomplishing prior objectives.
What evidence (for example surveys) do we have concerning company objectives?
An example of information showing firms objectives can be shown in the questionnaire below. The study was carried out by Shipley (1981). He gave the questionnaire to 728 UK companies to come to some sort of conclusion as to how many companies were true profit maximizers. To do this he claimed that companies who answered to questions 1)a) and 2)d) were profit maximizers. After his findings he concluded that only 15.9% of firms had a prime objective of profit maximization. From the questionnaire we may also conclude that firms who answered to questions 1)b) and 2)c) may be price satisfiers as they try to achieve satisfactory profits that is regarded to be important to the firm.
All Respondents (%)
1) Does your firm try to achieve:
a) Maximum profits
b) Satisfactory profits
2) Compared to your firm’s other leading objectives, is the achievement of a target profit….regarded as being:
a) Of little importance
b) Fairly important
c) Very important
d) Of overriding importance
Those responding with both 1)a) and 2)d)
Source: Applied Economics 10th Ed. Alan Griffiths & Stuart Wall
How would pricing policy reveal company objectives?
Pricing policies may reveal companies objectives, as depending on the business’s pricing strategy, the business will operate according to the pricing policy.
If a business uses a predatory pricing policy, by lowering prices a business can create specific barriers of entry to new competitors and make it harder for new businesses to enter to the market. This is because new firms would have to operate with low prices and high start up costs. This type of pricing policy would be found in a monopolistic market as monopolies can afford to lower prices due to their existing high sales. Using a predatory pricing policy can indicate that a monopoly’s objective is growth as it is increasing its market share as new competition will be eliminated in addition to an increase in sales.
Another pricing policy is competitive pricing. This is where businesses set their prices in accordance to their competitors. For example, bread is generally priced the same (70p-ï¿½1) as it is massed produced by a number of companies. Firms price the product the same as they do not want to lose customers to their competitors. This type of pricing policy would be found in a perfect competition market. By using competitive pricing it can show that a firm’s objective is profit satisficing, as it is happy to sustain its market share by producing acceptable levels of profit to continue running the firm successfully.
Are there differences between the objectives of large and small companies?
Although the objectives of most small and large firms may be to maximise profit, the scale of the objectives invariably depend on the business size. For example, large firms may want to maximise profits whereas smaller firms may be to profit satisfy. This is because smaller firms may only aim to satisfy its shareholders (most likely the owners) and allow them to be in a comfortable position. As oppose to most large firms who want to receive as much profit as possible and increase their position in their market.
Survival is most likely to be an objective of smaller firms as the dominance of larger firms within its market forces smaller firms to survive as oppose to concentrating on their original objectives. Meaning larger firms are less likely to have survival as an objective as they may be in a better position within the market due to already being established. This means that small firms cannot implement new objectives e.g. growth, increasing sales, as rapid as larger firms, and therefore, do not have the flexibility and resources to accomplish their objectives.
What did Karl Marx believe about the aims of companies in the capitalist system?
Karl Marx believed that capitalists take advantage of the difference between the labor market and the market for whatever commodity is produced by the capitalist. He observed that in every industry input unit-costs are lower than output unit-prices. Marx called the difference “surplus value” and argued that this surplus value had its source in surplus labour, the difference between what it costs to keep workers alive and what they can produce. Wikipedia (2004).
Davies, H. (1989) Managerial Economics, London: Pitman Publishing
Griffiths, A. and Wall, S. (2004) Applied Economics. 10th Edition, Essex: Pearson Education
Sloman, J. and Sutcliffe, M. (2004) Economics for Business. 3rd Edition, Essex: Pearson Education
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