the-objectives-of-firms

Profit Maximisation

• Most firms have the rational business objective of profit maximisation

  • Profits benefit shareholders as they receive dividends and also increase the underlying share price

    • An increase in the underlying share price increases the wealth of the shareholder

• To achieve profit maximisation, firms should follow the profit maximisation rule

  • When marginal cost (MC) = marginal revenue (MR) then no additional profit can be extracted by producing another unit of output

  • When MC < MR additional profit can still be extracted by producing an additional unit of output

  • When MC > MR the firm has gone beyond the profit maximisation level of output

    • It is making a marginal loss on each unit produced beyond the point where MC = MR

• In reality, firms may find it difficult to produce at the profit maximisation level of output

  • They may not know where this level is

  • In the short term, they may not adjust their prices if the marginal cost changes

    • Marginal costs can change regularly and regular price changes would be disruptive to customers

  • In the long- term, firms will seek to adjust prices to the profit maximisation level of output
     

  • Firms may be forced to change prices by the competition regulators in their country (especially natural monopolies)

    • The profit maximisation level of output often results in high prices for consumers

    • Changing prices changes the marginal revenue

Diagram: The Profit Maximising Level of Output

Diagram analysis

• This firm has market power as the MR and average revenue (AR) curve are downward sloping

• At the profit maximisation level of output (MC = MR)

  • The selling price is P₁

  • The average cost is C₁

  • The supernormal profit =

Evaluating Profit Maximisation as a Business Objective

• Apart from the very significant advantages that are offered by pursuing profit maximisation, there are some distinct disadvantages too

The Advantages & Disadvantages of Pursuing Profit Maximisation

Alternative Business Objectives

• The firm can have objectives other than profit maximisation. These are the reason for their existence or the desired focus of their owners

1. Growth

• Some firms have the business objective of growth

• A firm growth can be calculated by using the number of employees, market share, size of profits & market capitalisation

• Firms with a growth objective often focus on increasing their sales revenue or market share

• Firms will also maximise revenue in order to increase output & benefit from economies of scale

• A growing firm is less likely to fail

2. Survival

• In the short term, many new firms focus solely on business survival

• Generally, as much as 25% of new firms fail in their first year of business

• Once a firm is established, it may then begin to focus on profit maximisation as its new objective

3. Social Welfare

• More firms than ever are launching with a social welfare objective

  • These typically include a focus on climate action & addressing poverty or inequality

• They still require profit to survive, but will accept less than if they were profit maximising as long as they are meeting their social objective

4. Satisficing

• Firms can opt to make a satisfactory level of profit and not seek to maximise profits

• They may aim to make enough money to keep the owner/shareholders happy

  • E.g a small family owned business may make enough profits to support the family but not pursue more profits. Satisficing can allow firms time to pursue other objectives, such as leisure or a better work-life balance

Divorce of Ownership from Control

• Divorce of ownership from control occurs when there is a clear split between the ownership of firm and those who run the business on a day-to-day basis 

  • It usually occurs in larger firms where there is a distinction between ownership and management 

• The separation of ownership from control is linked to the principal-agent problem

  • Firm owners, such as shareholders (principals), appoint managers (agents) to make decisions and represent their interests. Managers may have differing goals and motivations, leading to conflicts of interest

Examples of Divorce of Ownership of Control