Objectives of the Firm

Question 1

What is the key assumption of a firm’s objective?

Answer 1

Profit maximisation

Question 2

What determines whether or not the firm’s objective will be profit maximisation?

Answer 2

Which stakeholder is dominant

Question 3

What is a stakeholder?

Answer 3

Anyone affected by the business, e.g. owners, workers, customers, government etc

Question 4

What is the objective if the owner is the dominant stakeholder and why?

Answer 4

The objective will be profit maximisation because the owner receives the profits

Question 5

Why is the owner the dominant stakeholder in small firms?

Answer 5

Because the owner runs the business and so performs the role of a manager.
This is known as a sole trader

Question 6

What does it mean to have unlimited liability?

Answer 6

This means the owner is responsible for whatever debts the business has and personal finance is at risk

Question 7

How does a firm achieve limited liability?

Answer 7

When it is owned by shareholders, also the names business will end with ltd or plc

Question 8

What does limited liability mean?

Answer 8

The risk to the shareholder (owner) is only the money directly invested in the business and not personal finance/ assets - there is legal distinction from the business and owner

Question 9

Why is limited liability better for an economy?

Answer 9

Limited liability raises capital and efficiency because firms will invest more as it is less risky - won’t lose personal finance for investing

Question 10

What does it mean that limited liability leads to moral hazard?

Answer 10

This means that shareholders are more likely to take risky decisions as personal assets are not at risk - this reduces efficiency as more bad decisions are made

Question 11

Why do businesses sell shares?

Answer 11

Shares are sold to raise funds in a quick and cheap way which can be used to raise capital

Question 12

Why are managers hired to run the business and not shareholders/ owners? (3 reasons)

Answer 12

1) The shareholder only holds shares to make dividends (a share of profits) and make money on share price - therefore unlikely to know about how the business actually operates

2) Shares make individual owners weak - in large firms each individual shareholder only has a small part of ownership which means it would be difficult to organise management amongst many shareholders

3) Larger firms get more complex to run meaning expert managers will be needed to make decisions

Question 13

What are the 3 objectives of a manager?

Answer 13

1) High pay
2) High market share
3) Work life balance

Question 14

How does the manager wanting high pay mean the firm won’t profit maximise?

Answer 14

Managers pay is often based on sales as sales are an easy way to measure performance, however increasing sales will not profit maximise

Question 15

How does the manager wanting high market share mean the firm won’t profit maximise?

Answer 15

The manager wants a higher market share to feel more important and powerful (ego), however market share is based on sales/ output which can reduce profits (diseconomies of scale)

Question 16

How does the manager wanting work life balance mean the firm won’t profit maximise?

Answer 16

Achieving sales maximisation is easier than profit maximisation, it is difficult for firms and workers to know their MR and MC. Tracking sales maximisation, on the other hand, is much easier as you can just sell as much as possible and it’s easy to incentivise workers to sales maximise

Question 17

What is the formula for sales maximisation and profit maximisation?

Answer 17

Sales - AR = AC (highest quantity without making a loss)

Profit - MR = MC

Question 18

What does the principal agent problem refer to?

Answer 18

The conflict between shareholders (principals) and managers (agents), shareholders wanting profit maximisation and managers wanting sales maximisation

Question 19

What happens if managers are the dominant stakeholder and on the contrary what if owners are dominant?

Answer 19

Owners = output and price moves closer towards profit maximisation

Managers = output and price moves closer towards sales maximisation

Question 20

Why is it unlikely that shareholders will be completely dominant?

Answer 20

Shareholders will lack information about profit maximisation so cannot hold managers to account for it, and in large firms shareholders will lack information on how to run the business

Question 21

Why is it unlikely that managers will be dominant?

Answer 21

Shareholders own the business and therefore risk their money, therefore they will notice if they are not getting any profit and will replace managers who yield low profit

Question 22

What is satisficing behaviour?

Answer 22

The manager will give just enough profit to keep the shareholders satisfied - if shareholders are less dominant then this will obviously mean less satisficing behaviour and vice versa

Question 23

Why are larger firms likely to be closer to sales maximisation than smaller firms?

Answer 23

Larger firms have more shareholders and are more complex therefore shareholders have little information and are less dominant. In small firms the opposite is true (less shareholders and less complex) so profit maximisation is closer

Also small firms likely have to profit maximise to remain in the market (small firms usually exist in competitive markets)

Question 24

What is the formula for revenue maximisation? (satisficing behaviour)

Answer 24

MR = 0

Question 25

How can managers be incentivised to profit maximise? - and how could this not work?

Answer 25

Managers can be given shares and become shareholders to be incentivised to profit maximise

This will depend on the value of shares compared to their overall pay (if it’s less then it may not be enough to incentivise them).

Also a manager cannot only be paid in shares as they are illiquid (cannot be traded for goods and services usually).

Also the manager will still want work life balance and ego.

Also it can lead to short termism, managers are unlikely to have a long term commitment to a firm therefore with shares they would benefit from short term profits and to do this they can reduce costs excessively e.g. sell capital