Objectives of Firms and Principle Agent Problem Flashcards
What are the different business objectives a firm may have? What is the primary objective?
The primary objective and the objective that we assume all firms to be pursuing in market theory is profit maximisation. This occurs when MC = MR
Alternative Objectives Include:
- Sales Maximisation
- Revenue Maximisation
- Survival
- Business Growth
- Increasing market share
- Profit satificing
Explain why profit maximisation occurs where MC = MR?
What is sales maximisation?
Draw a firm diagram showing a firm sales maximising. Label all the key points.
Why may a firm aim to sales maximise rather than profit maximise as part of their long term strategy?
SALES MAXIMISATION: Sales maximisation is when a firm maximises its sales (greatest quantity), without making a loss. This occurs where Price = Average Cost so that only normal profit is made. This is where the quantity sold is greatest along the demand curve, whilst normal profit is still being made
Firms may aim to sales maximise (ATC = AR) as part of their long term strategy.
- Example: Sony sold their PS3’s at a price where AR = ATC, meaning only normal profit was made. This however allowed them to maximise the amount of PS3’s they sold as prices were as low as they could possibly be whilst not making losses. They are then able to set the price of thier games very high. The demand for such games will be price inelastic as consumers have already incurred a sunk cost of purchasing the PS3, so they will be able to make massive supernormal profit on these games.
Firms may also sales maximise in order to increase their market share. This increases monopoly power, thus allowing them to make greater profits in the long run. By setting prices lower and maximising sales, consumers may switch over from rival firms, pushing rivals out of the market and increasing market share. This gives a strong position to dominate the market in the future and maximise profits later, as they will have more price setting ability and more price inelastic demand by removing rivals from the market.
Managers and directors may also want to sales maximises in order to reach sales targets so that they can maximise their individual bonuses.
Sales maximisation is often used as part of a long term growth strategy.
What is revenue maximisation?
Draw a firm diagram showing a firm sales revenue. Label all the key points.
Why may a firm aim to revenue maximise rather than profit maximise as part of their long term strategy?
Revenue maximisation occurs when the total revenue from sales in maximised. This occurs when the marginal revenue = 0, meaning total revenue is maximised.
Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being the cheapest supermarket can help attract customers.
Economies of scale. Lower prices and higher sales can help firms with high fixed costs gain economies of scale (lower average costs). This could lead to lower prices for consumers. Pursuing revenue maximisation may be a clever way to increase long-term profitability. By gaining market share, firms enable economies of scale, greater sales and more market share. Therefore, in future, they will have greater ability to increase prices.
Put competitors out of business. Pursuing sales maximisation may enable large firms to push rivals out of business. For example, a large supermarket with economies of scale could sell goods so cheaply; smaller rival firms can’t compete and go out of business. This enables the firm to have more market share and profit in the long term. Consumers could benefit from lower prices in the short-term, but if firms do go out of business, then they will have lower choice and face the prospect of less competition in the long-run.
Greater influence. Some firms are not motivated by profit, but by exposure and influence in society. For example in the newspaper market, the newspaper may have a political agenda to promote. They may be happy to accept more political influence (due to cheap newspapers) rather than higher profit.
Managers and directors - managers and directors may prefer to work for larger companies with greater prestige. By revenue maximising and increasing long term market share, firms can appease managers and directors and attract the best managers in the market who want to work for the largest firms
Give an example of a firm which successfully pursued market share maximisation in order to increase long term profitability.
Wallmart - expand
What is profit maximisation?
Draw a firm diagram showing a firm maximising profits. Label all the key points.
Why may a firm aim to profit maximise in the short term?
Profit can be used to pay higher wages to owners and workers. Shareholders are driven by the profit motive and want to receive financial reward for the risk + entrapresunship they take for investing into the firm. If shareholders are not kept happy, firms could lose shareholders. This will reduce shareholder investements and could lead to shares being sold, thus devaluing the firm.
Retained profits are a cheap source of finance for the future and can be used to invest in research & development.
Profit enables the firm to build up savings, which could help the firm survive an economic downturn. For example, in a recession, a firm could see a temporary loss, but if the firm has a reasonable level of savings and a history of profitability, the bank will be more willing to keep lending.
Profit can be used to pay higher dividends to shareholders, thus keeping shareholders happy.
Profit can be used to pursue other objectives in the long run such as buisness growth, by providing funds for takeovers and mergers
Explain why a firm may want to pursue business growth rather than profit maximisation and how they would go about doing this?
how is rev max increasing market share?
Pursuing goals of increasing market share and growth comes at the expense of profit. This can be achieved through mergers and acquisitions, sales maximisation or revenue maximisation
This can help firms push out rivals from the market, as consumers switch over from rivals to the firm selling at lower prices and larger quantities. This gives the firm greater monopoly and price setting power, thus allowing them to make greater SNP in the long run when demand is more price inelastic and price setting power is greater.
If greater economies of scales can be accessed, lower long run average costs and increasing long term profitability. A firm may diversify, and therefore enjoy risk bearing economies of scale, or other economies of scale (describe a few indivudually in an essay)
It can also lead to firms gaining consumer loyaltly, which makes their demand more price inelastic and therefore can help maximise profits further down the line in the future.
How to do this:
- Expanding production through mergers or takeovers (horizontal integration = purcahsing of rivals)
Vertical intergration = purchasing a firm in another area of the supply chain
- sales maximising/revnue maximising to increase quantity sold, increasing a firms consumer base and reducing the market share of rivals
Draw a single firm diagram lablelling the points at which sales, profit and revenue maxmisation occur.
Explain what is meant by profit satisficing. Why may a firm in real life want to profit satifice?
Why is it important for a firm to keep shareholders happy?
- if shareholdres are unhappy they will stop investing in the company, reducing available investement funds
- they will sell shares, flooding the market thus devaluing the company.
Explain why a firm may want to pursue survival rather than profit maximisation and how they would go about doing this?
What is profit satisficing?
Profit satisficing is when firms sacrifice profits in order to satisfy as many key shareholders as possible. This occurs when there is a divorce of overship and control. The owners (shareholders) wish to maximise profit, whilst the managers and workers do not have the same incentive (prefer to work less hard and only aim to maximise their individual bonuses).
The firm therefore makes enough profit to keep shareholders satisfied, whilst not making workers and mangers work too hard, thus keeping all stakeholders happy.
Shareholders want profits since they earn dividends from them. Managers might not aim for high profits, because their personal reward from them is small compared to
shareholders. Therefore, managers might choose to earn enough profits to keep shareholders happy, whist still meeting their other objectives
Who are they key shareholders within the firm? What are their wants?
The Owner/CEO
The Shareholders
The workers
The consumers
What alternative firm goals may a firm pursue?
Cooperate reputation
Ethical Goals (where there are philanthropic owners)
Why might profit maximising not the most benifical objective alone for a firm?
