Chapter 12 - Objectives of business Flashcards
At what level will profits be maximised?
They will be maximised at the level of output where marginal revenue (MR) is equal to marginal cost (MC)
What is the principal-agent problem?
Arises from conflict between the objectives of the principals and their agents, who take decisions on their behalf.
What causes the principal agent problem?
In a public limited company, the shareholders delegate the day-to-day
decisions concerning the operation of the firm to managers who act on their behalf. In this case the shareholders are the principals, and the managers are the agents who run things for them. In other words, there is a divorce of ownership from control. The degree of accountability of
managers to the owners may be weak when the shareholders are a diverse group of individuals.
If the agents are in full sympathy with the objectives of the owners, there is no problem and the managers will take exactly the decisions that the owners would like. Problems arise when there is conflict between the aims of the owners and those of the managers. There are various motivations that managers may pursue in this situation. Shareholders (the owners) are likely to want the firm to maximise its profits, but the managers may wish to pursue other objectives - such as their own utility, for example.
The principal-agent problem arises primarily from asymmetric information. This arises because the agents have better information about the effects of their decisions than the owners (the principals), who are not involved in the day-to-day running of the business. In order to overcome this information problem, the owners must improve their monitoring of the managers’ actions, or provide the managers with an incentive to take decisions that would align with the owners’ objectives. For example, if the managers are offered bonuses related to profit, they will be more likely to try to maximise profits.
What is X-efficiency?
It occurs when a firm is not operating at
minimum cost, perhaps because of organisational slack
How is sales revenue maximisation a maximisation objective?
Managers might set out with the objective of maximising sales revenue. One reason is that in some firms managerial salaries are related to sales revenue rather than profits.
The shareholders might not be too pleased about this. The way the firm behaves then depends upon the degree of accountability that the agents (managers) have to the principals (shareholders). For example, the shareholders may have sufficient power over their agents to be able to insist on some minimum level of profits. The result may then be a compromise solution.
How is sales volume maximisation a maximisation objective?
In some cases, managers may focus more on the volume of sales than on the resulting revenues. For example, a newspaper publisher may be more concerned about circulation figures than revenue.
Again, the extent to which the managers will be able to pursue this objective without endangering their positions with the shareholders depends on how accountable the managers are to the shareholders. Remember that the managers are likely to have much better information about the market conditions and the internal functioning of the firm than the shareholders, who view the firm only remotely. This may be to the managers’ advantage.
How is growth maximisation a maximisation objective?
Firms may wish to increase their size in order to gain market power within the industry in which they are operating. A firm that can gain market share, and perhaps become dominant in the market, may be able to exercise some control over the price of its product, and thereby influence the market.
Some firms grow simply by being successful. For example, a successful marketing campaign may increase a firm’s market share and provide it with a flow of profits that can be reinvested to expand the firm even more. Some firms may choose to borrow in order to finance their growth, or to issue shares (equity).
Such organic growth may encounter limits. A firm may find that its product market is saturated, so that it can grow further only at the expense of other firms in the market. If its competitors are able to maintain their own market shares, the firm may need to diversify its production activities by finding new markets for its existing product, or perhaps offering new products.
Instead of growing organically - that is, based on the firm’s own resources - many firms choose to grow by merging with, or acquiring, other firms. The distinction here is that an acquisition (or takeover) may be hostile, whereas a merger may be the coming together of equals, with each firm committed to forming a single entity.
Growth in this way has a number of advantages: for example, it may allow some rationalisation to take place within the organisation. On the other hand, firms tend to develop their own culture, or way of doing things, and some mergers have foundered because of an incompatibility of corporate cultures.
How is utility maximisation a maxmisation objective?
Oliver Williamson argued that managers
would set out to maximise their utility. Just as consumers gain satisfaction from consuming goods, it is argued that managers gain satisfaction in various ways. For example, they may enjoy the status of having a large team of people working for them, or they may like to have discretion over the way in which profits made by the firm are used, perhaps allowing them to have a large and well- appointed office or a prestigious company car. Again, such activity would take the firm away from its profit-maximising position, and may result in X-inefficiency.
How is long run profit maximisation a maxmisation objective?
Firms may be prepared to take a long-term view of their situation. There may be times when the decision to maximise profits in the short run may damage their long-run prospects. For example, firms may undertake costly investment now in order to reap higher profits in the long term. Or firms may delay adjusting price to an increase in costs so that they maintain customer loyalty. In other words, short-run profit maximisation may not always be in the best long-run interests of the firm.
What is bounded rationality?
A situation in which firms’ ability to take rational decisions is limited by a lack of information or an inability to interpret the information that is available
What is satisficing?
Behaviour under which the managers of firms aim to produce satisfactory results for
the firm (e.g. in terms of profits) rather than trying to maximise them
How is bounded rationality a non-maximisation objective?
It is a situation in which firms try to do their best, but cannot achieve profit maximisation because they do not have enough information about market conditions, or lack the ability to interpret the market environment. Firms may therefore decide to do enough to survive, but not strive for maximisation.
How is profit satisficing a non-maximisation objective?
Businesses may not set out to maximise anything, either consciously because they have other motivations, or as a result of the principal-agent issue. For example, it might be that managers simply prefer a quiet life, and therefore do not push for the absolute profit-maximising position, but do just enough to keep the shareholders off their backs. Herbert Simon referred to this as ‘satisficing’ behaviour, where managers aim to produce satisfactory profits rather than maximum profits.
How is social welfare a non-maximisation objective?
Not all firms aim to make profits, and enterprises such as charities are non-profit making bodies that set out to improve social welfare, in their home economy or elsewhere in the world.
Non-profit-making bodies clearly pursue very different objectives from firms that try to maximise profits or some other economic variable. There are many examples of such organisations that raise funds by various means to distribute to those seen to be in need.
What is corporate social responsibility (CSR)?
Actions that a firm takes in order to demonstrate its commitment to behaving in the public interest
How is CSR a non-maximisation objective?
Even firms that set out to make profits may wish to develop a favourable reputation by demonstrating a commitment to acting in ways that benefit society at large, or that improve the welfare of their employees and the community in which they are located.
This notion of corporate social responsibility (CSR) has become widespread, with firms devoting resources to promoting community programmes of various kinds and encouraging their employees to engage in volunteering activities. The motive for engaging in such activities is not necessarily humanitarian, to the extent that public demonstration of a commitment to CSR may enhance the reputation of a firm, and therefore boost its market position.
Indeed, it may now be that CSR has become a prerequisite for firms’ survival. If it is perceived that failure to engage with CSR has a major impact on firms’ sales, then it becomes crucial for a firm to be able to demonstrate its commitment in order to compete with its rivals. Devoting resources to CSR then becomes part of a firm’s strategy to safeguard its market position.
What are the factors that influence a firm’s choice of objectives?
- The owners of the firms
- The managers
- The relationship between the owners and managers
- The market environment
How does the factors influence a firm’s choice of objectives?
The owners of the firm (the shareholders) will have views of what the firm should have as a main objective. To serve their best interests, they may want the firm to maximise profits, as this provides them with an income flow. If the owners are far sighted, they may realise that taking a long-term view may serve them best. In other words, they may be prepared to sacrifice short-run maximisation in favour of a strategy that will bring higher profits in the future.
The managers who are responsible for the day-to-day decision making may take a different view. They may prefer to keep the shareholders happy by making sufficient profit, while taking life more easily than if they are continually striving for maximisation.
The relationship between the owners (the principals) and the managers (their agents) then becomes crucial. The key issue here is the extent to which the shareholders are able to hold the managers accountable for their actions. It may be difficult to coordinate the views of multiple shareholders in order to penalise managers who diverge from the owners’ prime objective - even if the shareholders were actually able to observe the behaviour of managers sufficiently closely to know whether or not they are acting against the owners’ interests.
The market environment in which the firm operates is also significant in determining the choice of objectives.
What is the evaluation of a firm’s objectives?
The discussion has revealed a range of reasons explaining why firms may depart from profit maximisation. Does this mean that it should be abandoned as an assumption?
It could be argued that some of the strategies adopted by firms may seem to diverge from profit maximisation in the short run, but may result in the maximisation of profits in the long run. For example, if all firms in a market are engaging in CSR in order to improve credibility among their customers, then it could be argued that this expenditure becomes part of operating costs, and a necessary part of maintaining the market share needed to maximise profits in the long term.
From an economic modelling perspective, being able to assume that firms maximise profits allows the economist to come to an understanding of firms’ behaviour under a simple and clear assumption. This offers much more straightforward insights into this behaviour than trying to implement some of the more complex assumptions that could be made about what motivates firms’ decisions. Profit maximisation then provides a benchmark for other, more complex models that enable an evaluation of how differently firms may behave under alternative assumptions. So even if it is not the case that firms always act to maximise profits, it is a useful starting point to ask how they would behave if they did maximise profits, and then explore alternative theories using profit maximisation as the benchmark against which to compare other models of behaviour.
The complexity of business organisations gives credence to the potential importance of the principal-agent problem, and the way that this highlights the discretion that managers may have in pursuing a variety of objectives. However, it could be argued that in the end the performance of businesses in delivering value to their shareholders will ultimately determine their success or failure.
What is productive efficiency?
When a firm operates at minimum average cost, choosing an appropriate combination of inputs and producing the maximum output possible from those inputs
What is static efficiency?
Efficiency at a particular point in time given the resources and technology available
