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THE OBJECTIVES OF FIRMS

THE OBJECTIVES OF FIRMS

The Firm’s Objectives

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Lesson Objectives Appreciate that firms, in addition

to profit maximisation, have a range of objectives that they endeavour to satisfy

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ConnectorIn pairs explain the following terms: • Profit-maximisation • Normal profit • Supernormal profit (Abnormal profit) • Subnormal profit;

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Big Picture

• We will challenge the concept that firms exist to maximise their profits and we will use other terms such as ‘satisficing’ to try to explain the real-world behaviour of firms.

• It is in this area that economists are able to draw on the empirical evidence that is more the prerogative of business and management studies.

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Big Picture• To arrive at the learning outcomes you will do the following:• Listen to teacher demonstrations on PPP• Draw graphs• watch VIDEO • ‘Stretch and challenge’ Questions• Group work• Independent work• Class discussion• Short presentation• Demonstration on the board• Pair marking• Advise on examiner’s tip

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Lesson Outcome

Appreciate that firms may have a diverse range of objectives

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Key Terms• Public Limited Company

(PLC) ; • Corporation ; • Director ; • Perks; • Dividends; • Share options; • Annual general Meeting

(AGM); • Activist shareholders; • Hostile bid;

• Stisficing; • Shareholders; • Carbon footprint; • Corporate citizenship; • Market share; • Market power; • Rational choice theory; • Capital market discipline; • Delisting; • Innovation.

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A Firm’s Objectives

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A Firm’s Objectives• The traditional theory of the firm argues that the firm’s sole

objective is to maximise its levels of profits

• And suggests that an entrepreneur will change levels of output every time there is a change in the levels of prices or costs.

• However, in a world concerned about negative externalities and the destruction of the environment, a firm that ignored these considerations in order to increase its profit levels would be likely to lose custom and receive heavy censure.

• Thus is shown in the case study below.

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Case Study – page 20

‘We Blew it’ – Nike admits to mistakes over child labour

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A Firm’s Objectives

• The theory of profit maximisation can be criticised and challenged on a number of grounds and a number of competing alternatives have been advanced.

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The Divorce of Ownership and Control

• Individuals who own their own firms may be extremely keen on profit maximisation

• But in large firms there is a gap between ownership and control.

• Shareholders who own the firm, want to maximise their returns – profits and keep cost low, but are not in position to run the firm.

• Shareholders appoint directors to represent their interests and directors appoint managers to run the company.

• Professional managers are given control and the interests of managers may be different from that of the shareholders.

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The Divorce of Ownership and Control

• Directors and managers salaries are determined more by the size of the business than the profitability of the firm

• This may colour their actions and they may seek market size in terms of its output, sales and employment rather than profitability.

• This would suggest that the sales growth will be an important objective of the board of directors

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Satisficing• Means the firm is producing satisfactorily but not maximum

profit.

• Firms are more likely to satisfice than maximise, that is, they will make what is acceptable and satisfactory rather than achieve the optimal solution.

• This means that the firm will make sufficient profits in order to keep shareholders happy but will not waste time and resources seeking the optimal solution.

• A firm that is satisficing may produce a range of outputs that are within its target level of profits rather than the specific profit-maximising output.

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Satisficing• A profit maximising firm will

produce at the output that maximises profits, Pmax, giving an output of OB.

• A satisficing firm that does not want to make a smaller profit than that of Psat has a range of possible outputs between 0A and 0C.

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Social Responsibility• Some large firms now include ‘social responsibility’ among

their objectives,

• Which means they pay due regard to the needs of the stakeholders of the business – employees, customers and even national targets, such as reducing their carbon footprint.

• These so-called activities of corporate citizenship are likely to increase the firm’s costs and so reduce its level of profits.

• However, some stakeholders argue that such caring activities

do not always conflict with profit maximisation.– E.g. good staff are easier to attract and retain by firms that are seen as

socially responsible, and this reduces the costs of staff turnover.

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Sales Maximisation Theory

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Sales Maximisation Theory• Suggests that managers want the firms they work for

to be as large as possible• As working as a high level manager for a very large

corporation is an extremely prestigious position.• Managers may be receiving sales-related bonuses

and,• In this case, the manager might increase sales up to

the point where MR is zero and TR is maximised.• This would be at the output of 400 units in Figure2.2.

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Sales Maximisation Theory• This would be at the output of 400

units

• And as Marginal Costs are more likely to be positive than zero, the firm will not be maximising its profits by producing where MR = MC but maximising its sales revenue,

• And this will reward managers rather than shareholders who would benefit from profit maximisation.

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Sales Maximisation Theory• A further argument is that sales are the key to

market share and possibly market power, and that growth is the key to future profits and managerial security.

• Managers may be reluctant to undertake short-term risky ventures, even if the profits are large as failure to achieve success could terminate their careers.

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Inability to Profit Maximise • One of the problems faced by a profit-maximising firm is the assumption that firms

have complete information about the costs and benefit of each option and they compare the options and then make a rational choice.

• The rational choice theory is can be unrealistic and that firms lack the information to make the choices that profit maximisation suggests.

• In order to set prices, a firm needs to know its marginal cost of producing the good, as well as the elasticity of demand – how responsive customers will be to changes in prices.

• In practice, real-world firms are typically very complex, produce multiple goods, and detailed information on marginal cost is rarely available.

• These factors make it almost impossible for a firm to make accurate assessment of whether it is profit maximising.

• In addition, there is likely to be a natural time lay between accumulating and processing information, which means that important decisions may be made too late to maximise profits.

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Organisational Theory• According to profit-maximising theory, firms will choose an

output and price that is the most profitable.

• Organisational theory stresses that in large firms, decisions are made after much discussion by groups and committees and once they are agreed and adopted they are changed only reluctantly.

• Organisational theorists suggest that satisficing will take place as the organisation pursues a number of goals, such as increasing their market share or levels of sales.

• Profit maximisation is not then the major driving force of the firm, so an output could be chosen that ensures that the product will achieve market penetration rather than maximum profits.

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Cost Plus Pricing• This approach argues that firms follow a policy of

non-maximisation by choice. • They pursue a policy which is known as full cost

pricing.• In this theory the firm sets its price equal to average

cost, at normal capacity output, plus a conventional mark up.

• So the level of prices is the level of average costs plus, e.g., 25%, which is the conventional mark-up (level of profits) for the industry.

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Cost Plus Pricing• This Figure shows the long-run average variable

cost with the minimum efficient scale at 0A.

• Between 0A and 0B the firm experiences constant returns to scale.

• The cost plus view is that firms will produce somewhere between 0A and 0B and add a mark-up up when LRAVC changes.

• In this situation firms only change their prices when their average costs change substantially as a result, e.g., of an increase in the cost of raw materials

• But do not adjust their output to maximise profits along the lines suggested by the traditional theory.

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Long-run Profit Maximisation• The neo-classical theory of the firm suggests that firms will react to every shift

in market and alter their price and output accordingly.

• In reality this is unlikely to happen for a number of reasons, • If supply falls firms may avoid increasing prices too rapidly for fear of losing some

brand loyalty due to their perceived avaricious behaviour.• For large firms the costs of continually changing brochures and price lists is likely to

outweigh the benefits, unless large changes in market conditions occur.

• This has led to the development of the concept of long-run profit maximisation as an attempt to explain firms’ behaviour.

• The suggestion is that sales are the key to growth and growth is the key to future profits and managerial security.

• Firms will not attempt to increase short-run profits by undertaking risky, even if profitable ventures, as long-run profitability requires survival, and survival may require caution.

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Company Size• Profit maximisation suggests that all

companies will react in the same way and this is not borne out by observations in the real world.

• We have to accept that a small entrepreneurial company is likely to respond differently to a huge multinational that has a range of different objectives.

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In Conclusion• Profits are very important to a firm and firms are strongly

motivated in the search for profits and prefer to make more profits rather than less profit.

• There is pressure to make large profits in the short run to keep shareholders happy an to maintain the price of the company shares.

• At present any acceptable theory is likely to be profit oriented, especially in the short-run, because if the firms’ managers fail to make the profit their assets can achieve, they will be subject to a takeover bid by other firms that think they can use the assets more successfully.

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In Conclusion• The pressure of takeovers is likely to limit the discretion of

the managers to pursue other goals than profits.

• Such short-term behaviour may be to the detriment of the company’s long-run aims as it may preclude capital investment,

• Which, in the short run, would be extremely expensive and reduce profits but could prove to be extremely profitable in the long run.

• Some companies like virgin have delisted their shares in order to remove such short-run pressures.

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http://www.youtube.com/watch?v=JjjvQSmeWGQ&feature=related

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The various objectives that a business might have

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Examiner’s Tip

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Activity – page 24

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Answers1. Reasons could include:• concern over negative externalities• extremely complicated business making it difficult to accurately

calculate the profit-maximising level of output• directors’ salaries could be linked to the size of the business and market

share, rather than profits• firms could seek to maximise market power, which may reduce profits

in the short run but could lead to higher profits in the long run• difficult in practice to continually change the level of output in order to

maximise profits as it may mean that workers have to be laid off and then reemployed, which is difficult.

2. Total revenue is maximised when marginal revenue is zero. For profits to be maximised at this point, marginal cost would also have to be zero, and this is not possible. Students could draw a variety of diagrams, such as the relationship between TR and MR, or a graph showing AR, MR, MC and AC, indicating the revenue-maximising and profit-maximising points.

3. A public limited company (PLC) is a firm owned by a group of shareholders, and whose shares are traded on the stock exchange. People buy shares in order to maximise their returns, that is, their dividends (share of profit), so shareholders want profit to be maximised, which doesn’t necessarily occur at a point where average costs are minimised.

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The objectives of firmsInnocent’s objectives

Learning objectives: appreciate that in addition to profit maximisation, firms often have a range of other objectives that

they want to satisfy understand that firms can grow in different ways.Scenario• Innocent Drinks make smoothies, juices and ‘veg pots’, and are characterised by their ethical slant

on everything what they do. At just 10 years old, Innocent now has a total revenue of around £100m.

The Innocent ‘ethos’ is built around the four main principles advocated by its founders: ethical purchasing reducing/offsetting carbon emissions recycling charitable giving.These principles govern every decision made, from recruitment through to the purchasing of bananas

and advertising campaigns.Richard Reed, one of Innocent’s founders, has said that ultimately, Innocent’s objectives are to do with

growth and profit. Some might think that Innocent’s ethical stance would cause these objectives to suffer. However, many consumers buy Innocent products over the alternatives because of their inbuilt ethical approach, allowing them to feel like ‘do-gooders’. So, Innocent’s employees have to be both commercially minded, and altruistic – not an easy combination to find!

For the moment, Innocent’s founders are pursuing expansion in the European market, but are to work on global expansion when the time is right. As yet, there is no clear way forward; Adam Balon, one of the original founders, recently said that a sale of the company, a partial issue of publicly traded shares or simply continuing to grow organically were all options being considered. Achieving internal growth, however, is becoming more difficult as Innocent’s founders are having to delegate responsibilities, such as marketing and recruitment, that they have previously handled themselves.

Questions1. Explain what is meant by ‘total revenue’.2. Examine the importance of profit for companies.3. Using examples from the case study, and your own knowledge, outline other possible objectives

that a company such as Innocent Drinks might adopt.4. Outline reasons why achieving organic growth can be difficult for a company such as Innocent.5. Comment on the statement that ‘expansion via the sale of Innocent is the best way for the

company to grow’.

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AQA Examination-style questions, page 28.Data response question 1:

a) Marginal in economics refers to small increments. Many large companies would not be interested in the ‘marginal’ mines because it would incur significant cost to generate any revenue, that is, it would be small part of their overall profit. However, for a small company, such mines could generate enough profit.

b) Diagram should be similar to that shown in figure 09 from Chapter 2 of the student book. New technology would allow Petra to benefit from lower LRATC than De Beers; so, if costs are lower then profits are likely to be higher.

c) Define market share – relate it to De Beers previous strategy (that is, own as many diamond mines as possible). Explain why ‘higher returns’ (that is, higher profits) may be sought by De Beers (that is, profits provide funds for further investment, shareholders like high profits as it leads to higher dividends, reward for being entrepreneurial, etc.). Discuss advantages and disadvantages of two or three other objectives.

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Essay question 2:a) Reasons include: Reduces competition.

Strengths: less expensive to compete, higher brand loyalty. Weaknesses: could encourage investigation by Competition

Commission, could take advantage of market position and raise prices (thus reducing consumer surplus).

Control can be gained over companies further back/forward in the production process. Strengths: greater reliability of raw materials (delivery times,

quality, prices, etc.), reduce sources of raw materials for competitors.

Weaknesses: diseconomies of scale and miscommunication possible.

Leads to higher profits. Strengths: benefit from economies of scale thus reducing costs,

greater availability of funds for investment. Weaknesses: pay higher corporation tax, could take time for

increased market share to lead to higher profits.

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Essay question 2:b) Internal growth: Plough-back profit.

Issues to consider: reduced dividends for shareholders, depends on market interest rate (might be wiser to save), less risky than taking out a loan, small companies often have small profits so not much money available for investment in this way.

Borrow funds. Issues: costs of financing could be unmanageable if interest rates change, less

impact on shareholder dividends, easier for small businesses to borrow than use profits but often penalised with higher interest rates than larger, established companies.

Innovate/invent. Issues: not an easy or predictable thing to do, small companies may lack expertise

to take new ideas to market, can lead to rapid growth if the idea is good, leads to imitation.

External growth (mergers/acquisitions). Strengths: speedy, can be financially rewarding if there’s potential for asset

stripping, reduce competition, gain new brands without investing in marketing, can be cheaper than internal growth.

Weaknesses: could end up with diseconomies of scale, poor communication, poor culture fit between companies (especially if done very quickly), may be done for wrong reasons (satisfy egos of managers rather than for good business sense).