2.13. Objectives of Firms Flashcards
Profit Maximisation
- This occurs at the output level where MR = MC.
- This is the traditional objective of firms.
- However, this level of output can be difficult to calculate as it requires precise measurement but market conditions of demand and supply may be constantly changing.
Revenue Maximisation
- This occurs at the output level where MR = 0.
- This ensures the maximum possible total revenue can be made.
- Manager’s salaries may be linked to sales revenue.
- Also, investors prefer to invest in companies that have growing sales revenue.
- Furthermore, financial institutions are more likely to lend to companies where revenues are rising.
Sales Maximisation
- This occurs where firms produce as much output as possible whilst still making normal profits (AR = AC).
- Managers may want to achieve this because their salary and status might be linked to the size of the firm.
- Larger firms are also more difficult to takeover by rivals, which increases the chance of the manager keeping their job.
- Finally, bigger companies can experience economies of scale (falling average costs as firms increase their scale of production).
Profit Satisficing
- This involves a firm aiming to make a satisfactory level of profits.
- This then allows the firm to pursue other objectives (e.g. building relationships with suppliers, providing excellent customer service, looking after their employees) whilst also satisfying the needs of the owners.
Divorce of ownership from control
- This occurs where the shareholders own the business but the control and decision-making is done by management.
- Usually shareholders own very small shareholdings and have very little or no say in decision-making and how the business operates day-to-day.
- Therefore it is management that in effect determine the policies of the firm.
- This creates a situation of conflicting objectives, known as the Principal Agent Problem.
Shareholders in the Principle Agent Problem
- The owners of the business (“The Principals”) are usually shareholders.
- Their main objective is to receive strong returns from their shares in the form of rising dividend payments and rising share prices.
- Both of these are achieved through higher profits.
- Hence, the objective of Principals (owners) will be for the firm to profit maximise
- Why profit maximisation? Increase dividends and
Increase share price
Management in the Principle Agent Problem
- The controllers of the business (“The Agents”) are usually management.
- Objectives for management are usually about maximising sales revenue, since it is often more prestigious to work for a large and growing business as it will allow them to gain a larger income should they switch jobs
- Why maximise revenue? Prestige, Reputation, Bonus,
Status
The Principle Agent Problem
The problem that arises is how The Principals are able to make sure The Agents are acting in the best way possible to maximise profits when they may be pursuing other objectives of their own.
Dealing with The Principal-Agent Problem
- Managers are likely to have more expertise and information about the firm than shareholders.
- The key for shareholders is to try to align the interests of managers with their own interests.
- This can be done by linking manager pay to profits (e.g. profit sharing schemes) or to introduce share ownership for managers as part of their salary package:
1) Ensuring that financial rewards and incentives offered to managers are aligned with shareholder holder interests - e.g. based on the share price, dividends, profits achieved
2) Implementing suitable corporate governance procedures to ensure shareholders are protected as far as possible (e.g. through non-executive directors, management remuneration committees)
3) Company legislation ensuring that Directors are accountable for their actions to shareholders.
Survival
- New firms in an industry may simply wish to survive during their first few years of trading.
- In addition, changes in market conditions may cause survival to become the main objective.
- For example: a large and sudden decrease in demand (due to a recession or outbreak of disease) or rise in costs of production (due to a “supply shock”) may cause firms to focus solely on survival.
Deter Competition by Limit Pricing
- Preventing competition through limit pricing may become the objective if a firm feels threatened by the entry of new firms to the industry.
- New entrants will have higher costs and so may be put off by the low prices the existing firm charges.
Remove Competition by Predatory Pricing
- If a firm has market power, it can engage in predatory pricing and drive rivals out of the market.
- If the firm cuts prices to a level that is unprofitable for other firms, they will be forced out of the industry.
- Once they have left, the existing firm can raise prices
Strategic Objectives
- A firm may establish its objectives within a broad strategic approach, such as corporate social responsibility.
- For example, firms may wish to operate without causing environmental problems
Price Discrimination
charging different prices to different consumers for the same product that has the same cost of production.
Necessary Conditions for Price Discrimination
Firms must have market power.
1) Split the market up into different groups of buyers.
2) Need to keep the markets separate and prevent market seepage.
3) Different demand curves and different PED in each market.
