2e. Objectives of firms

Profit Maximisation

Profit is where revenue exceeds costs.

  • The owners will want higher profits as some of the profits will be distributed as dividends.
  • The prospect of dividends also increases demand for shares causing the share price to rise. This is popular with shareholders as they can make money on trading their shares
  • Retained profits can be reinvested back into the business to fund research and development
  • Higher profits can be used to build up reserves in case of a recession/global health pandemic.

Principal-Agent Problem

The principal-agent problem occurs when a decision maker is making those decisions for the benefit of someone else. In this case the managers are making decisions for the benefit of shareholders who might not get a say on how the firm is run.

In this case, we can say there is a divorce between ownership and control. The owners (shareholders) are not running the business on a day to day basis and are employing managers to do this for them. This means that the two stakeholders could have differing objectives.

Strategies for Dealing with the Principal-Agent Problem

  • Profit-related pay
    • Correlation may not mean causation e.g. the CEO may be very effective but a recession might lead to losses
  • Employee share-ownership schemes
    • This could incentivise managers to focus on short-term rather than long-term profits
  • Shareholder scrutiny of senior execs
    • Shareholders may not have the expertise to do this.

Revenue Maximisation

In some situations firms may prioritise increasing the amount of money coming into the business rather than the amount of profit they are making.

  • They are closing down
  • They have temporary cash flow issues (not enough money to pay for their costs)
  • To trigger bonuses for managers
  • Stock is about to go off/out of date (i.e. it is a sunk cost)
  • They need immediate funds to pay for a one-off investment or takeover
  • It is easier to calculate than the profit maximisation point
  • Large revenues aren’t as noticeable as large profits and hence are less likely to attract the attention of the CMA

Sales Maximisation

Sales maximisation is defined as the maximum level of output which can be produced without making a loss.

  • Producing at a high output (and hence lower price) will attract customers and can lead to brand loyalty in the long-run
  • Lower prices will build market share and can eliminate competition
  • Higher output can lead to economies of scale which can create profits in the long-run.
  • Larger firms are viewed as more prestigious and can attract better quality workers.

However

  • It is unsustainable- eventually a firm will need to make a profit to satisfy the owners
  • The CMA (competition authorities) may intervene if they think the firm has too much market power
  • If prices are set too low the firm could be fined for anti-competitive behaviour