The Objective of Firms

Question 1

Profit Maximisation is assumed to be the Objective of a firm

Answer 1

1. The traditional theory of the firm is based on the assumption that firms are aiming to maximise profit
2. But in reality, there are other objectives a firm might consider more important. E.g. revenue maximisation and sales maximisation are other common objectives

Question 2

Aiming for Other Objectives will Reduce Profit in the Short Run

Answer 2

A firm aiming to maximising profit will operate output level Q, where MR = MC. Firms that are aiming for other objectives will operate will operate at different output levels.

Question 3

Maximising Revenue means producing where MR = 0

Answer 3

1. Revenue is maximised when MR = 0
2. This happens at output level Q1 - a higher output than Q
3. If a firm is aiming to maximise revenue they will keep increasing output past the point where profit is maximised, as long as adding more output => to greater revenue.

Question 4

Maximising Sales means producing where AR = AC

Answer 4

1. A firm aiming to maximise sales will produce at an output level where AR = AC
2. This is the highest level of output the firm can sustain in the long run
3. Q2 is the sales-maximising output level - it’s higher than Q and Q1.
4. If sales increased further the firm would be making a loss.

Question 5

Maximising Profit might Only be an objective for the Long Run

Answer 5

1. Maximising profit in the long run sometimes means sacrificing profit in the short run
2. A firm may try to maximise sales or revenue in the short run, e.g. a firm might maximise revenue or sales to increase its market share, or to gain monopoly power so that it can make supernormal profits in the long run. Or high sales might make it easier for the firm to borrow money.
3. Some firms may even be willing to operate at a loss in the short run in order to make a profit in the long run. A firm may expect revenue to increase in the future, for example, once they’ve been in the market for a while and their brand recognition increases. Or a firm might expect to reduce costs when they’re able to output at higher production levels, and so they may keep operating at a loss while they build up the business.
4. A firm’s objective may be to simply survive in the short run by achieving normal profit. Then, when it’s established in a market, it can try to maximise profits.

Question 6

Some firms have Alternative Objectives

Answer 6

1. Some firms might aim for something not directly related to profit, revenue or sales. But these objectives are usually pursued while also aiming to make at least normal profit.
2. E.g. some organisations are ‘not for profit’ - they dont pay out profit to their owners and their main aim is to ‘do good’ or provide some kind of benefit to the public. Other firms will focus on producing high quality products, at the expense of maximising profits in the short run, to gain loyal customers.
3. Many firms are also interested in corporate social responsibility (CSR). This involves firms operating in a way that brings benefit to society, as well as trying to make supernormal profit. For example:
   - A firm may try to protect the environment by using sustainable resources.
   - A firm may support local businesses by using suppliers in their region.
   - A firm may choose to pay its workers above the standard market rate

Question 7

Divorce of Ownership from Control often happens as firms Grow

Answer 7

1. In small firms, the owner often manages the company on a day-to-day basis
2. As firms grow, the owners often raise finance by selling shares - the new shareholders become part owners of the firm. But the firm will actually be run by directors, who are appointed to control the business in the shareholder’s interests.
3. This is known as the divorce of ownership from control - the owner(s) of the firm are no longer in day-to-day control
4. Directors might have different objectives to the owners.
5. Employees and other stakeholders in firms may also have their own objectives and might have some level of control
   - The divorce of ownership from control can lead to what’s known as the principal-agent problem.
   - This is where a principal (e.g. shareholders) pays for an agent (e.g. a managing director) to act in their interests, but instead the agent acts in their own self-interest.
   - E.g. a firm’s shareholders will want a firm to maximise profits to increase the value of its shares. However, if the managing director’s pay or bonus is linked to revenue or sales, then they may choose to maximise those things instead.
   - Directors might also be keen to grow some aspect of the firm (e.g. sales or market share) because they enjoy running a large organisation, or because being in charge of a large firm will further their career.
   - Employees (another example of an agent) are likely to aim to increase their own pay or benefits (or just keep themselves in a job), ahead of aiming to make profits for the firm

Question 8

Owners can Retain Control with Accountability and Incentives

Answer 8

1. How much control the managers or directors of a firm have depend on how accountable they are to the owners. By holding managers or directors accountable, owners can tackle the principal-agent problem.
2. Shareholders can remove directors by vote if they’re not happy with them, but they often lack information that might make them do this.
3. Accountability means managers and directors having to justify what they’ve done in the past and explain their future plans and intentions
4. Owners might also try to encourage directors to aim for profit maximisation by offering incentives which make this an attractive objective for the directors to pursue - e.g. a bonus linked to profits, or free or discounted company shares.

Question 9

Sometimes people Satisfice rather than Maximise to Make Life Easier

Answer 9

1. Satisficing means trying to do just enough to satisfy important stakeholders, instead of aiming to maximise a quantity such as profits (or minimise something like costs). It’s sometimes described as ‘aiming for an easy life’.
2. Satisficing often arises when different stakeholders have different objectives, which might be conflicting.
3. E.g. rather than maximising profit, directors might aim to make ‘enough profit’ to stop shareholders gettin too concerned, and paying employees ‘high enough wages’ that they don’t look for work elsewhere or threaten to go on strike. (This is another example of the principal-agent problem)