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What is the most important objectives for firms?
Profit maximisation
How is profit calculated?
total revenue - total cost
At what point does a firm break even?
When TR = TC
At what point is profit maximised?
When MC = MR
What happens to profit at the point where MR>MC?
When MR>MC, profits rise when output increases
What happens to profit at the point where MR
When MR
Why would firms want to profit maximise?
o It provides greater wages and dividends for entrepreneurs
o Retained profits are a cheap source of finance, which saves paying high interest rates on loans
o In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company.
o Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run, so this will provide a stable price and output.
What is divorce of ownership?
The owners and those who control the firm are different groups with different objectives
What is the principal agent problem?
This is when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, such as a bonus, rather than maximise the dividends of the shareholders.
Why is the principal agent problem bad for a business?
The problem stems from the fact that shareholders may have an objective (profit maximisation) which differs from a managers. Rather than maximise profits, managers who possess a monopoly of knowledge about the actual running of the company concentrate on achieving managerial objectives such as maximising their career prospects.
Why do conflicts on interest arise between agents and principals?
Arise when the incentives that affect their behaviour are not the same. The agent bears the cost of fulfilling the task delegated by the principal, but does not usually receive the full benefit. This destroys the incentive for the agent to put the same effort into the task that would be the case if the agent were acting solely on their own behalf.
What are two reasons why an agent can get away with not acting in the best interest of a principal?
- The cost to the principal of sacking or punishing the agent may be too high relative to any benefit the principal will enjoy
- Information asymmetry may result from the fact that the agent knows more than the principal about what is going on in the business
What method can be used to realign the incentives between the owners and the directors and the managers they employ?
- Profit related pay
- Paying managers partly by giving them company shares
What are other possible business objectives other than profit maximisation?
- Growth maximisation
- Increasing market share
- Survival
- Quality
- Sales revenue maximisation
- The satisficing principle
Why is growth an objective?
Some firms might aim to increase the size of their firm. This could be to take advantage of economies of scale. This would lower their average costs in the long run, and make them more profitable.
Firms might grow by expanding their product range or by merging or taking over existing firms. Large firms are also more able to participate in research and development, which might make them more competitive and efficient in the long run.
Why is survival an objective?
Some firms, particularly new firms entering competitive markets, might aim to simply survive in the market. This is a short term view.
During periods of economic decline such as the 2008 financial crisis, when consumer spending plummets, firms might have survival as their objective, until there is economic growth again. Firms might aim to sell as much as possible to keep their market position, even if it is at a loss in the short run.
Why is increasing market share an objective?
This helps increase the chance of surviving in the market, and it can be achieved by maximising sales. For example, Amazon aimed to increase their market share in the e-reader market, by trying to sell as many Kindles as possible. They did this at a loss in the short run, but they gained customer loyalty and now they are a leading e-reader producer.
Why is quality an objective?
This helps increase the chance of surviving in the market, and it can be achieved by maximising sales. For example, Amazon aimed to increase their market share in the e-reader market, by trying to sell as many Kindles as possible. They did this at a loss in the short run, but they gained customer loyalty and now they are a leading e-reader producer.
Why is sales revenue maximisation an objective?
Revenue maximisation occurs when the level of output at which marginal revenue is zero. Firms may try to maximise sales revenue when managerial pay is linked to revenue rather than profit.
Why is the satisficing principle an objective?
Satisficing is achieving a satisfactory outcome rather than the best possible outcome. A firm is profit satisficing when it is earning just enough profits to keep its shareholders 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.
