Traditional objective of owner-controlledfirms.The “building block” of neoclassicaleconomics (not only for theory of firm butalso theories of price, and competitivemarkets)Assumption:Firm produces and sells single productFirms is managed by its owners. Where there isdivorce between ownership and control then themanagers still maximize profits on behalf of theowners.
The rules of profit maximization: Firm shouldproduces at the output which maximize itsprofit, which is outputRevenue – Cost =maxTR – TC = maxRevenue – cost = maxwhere:Marginal revenue = marginal costMR = MC
Criticisms of profit maximization:Based on the major assumption of neoclassicaleconomics: perfect information and rationaldecision maker -> not happen in real worldProfit concept relates to time. The theory doesn’tmention about long-run or short-run profit andtherefore could not explain the behavior of firm inmany casesDoesn’t take into account the complexity of themodern organization structure.Empirical studies also shown that profitmaximization is not the single objective of firm(only 26.1% of firms observed in 1981)
Defense of profit maximization:Profit maximization remains an importantassumption in economic analysis partly because itallows precise and predictive analysis of decisionsof firmsEmpirical studies still show profit maximizationremains an importance objective of firms.
Reasons:Sales revenue is a more useful short-term goal forthe firm than profit. Sales are measurable and canbe used as a specific target to motivate staff.Increase in revenue will more than offset anyassociated increases in costs -> Sales revenueincrease = profit increaseIncreasing sales hence the size of the firm make iteasier to manage.
1. How does the price – output combinationdiffer between a sales and profit-maximizing firm?2. How will managers react to the followingchanges in costs if they are profitmaximizers, on the one hand, and salesmaximizers, on the other:1. An increase in fixed costs?2. An increase in variable costs?
Assumption of the model:There are divorce between ownership and controlSenior management seeks to maximize its ownutility function rather than that of the owner.Content:Benefits related to management includingSalary :directly measurable in monetary termsNon-pecuniary benefits: related to expenditures on:StaffFringe benefits (free car, luxurious office, etc)Discretionary investmentThe satisfaction for management increase costs forfirm (directly and indirectly)
Comparison between Profit maximization & Utility:Profit maximization model:RP = AP = MP +DPManagerial utility model:RP = MP +DP – DE (with AP>MP)whereas:• MP: minimum profit• AP: Actual profit• RP: Reported profit• DP: Discretionary profit• DE: Discretionary expenditure
AssumptionDivorce between ownership and controlInternal structure of firm and the interactionbetween groups could influence the firm’sobjectives.Contents:Analyze the process by which firms decide on theirobjectivesAnalyze the objectives setting, achieving andadjusting
2. Evaluateperformance5. Aspiration level risesDecision making process
There are groups/ department of conflictinterestsThe above groups all have their influences tothe sets of objectives of the firmThe agreed objectives are satisfied to allabove groups.Identify the objectives that need to be set,those in turn will guide the decision makingprocess in individual department/ section
Some specific objectivesProduction objectiveStock objectiveSales objectiveMarket share objectiveProfit objectiveProcess to reach agreement:Negotiate among groups by paying additional moneyor more resources allocated to groups or individualsto make them content with the objective chosen bythe firm.Making side payment or policy commitments to keepgroups or individuals happy with any agreement.Once objectives are agreed, decision will be made forachieving objectives (such as price, advertising…)
Criticisms of the behavioural theory:Only adopt a rather short-term vision of what thefirm is trying to achieve.The theory does not explain the behaviour of firmsnor does it predict how actual firm react to changesin the external environment.The theory does not consider the behaviour ofother firms.
Divide into 6 different groups:Owners/ Investors of the companyFinance departmentSales departmentMarketing departmentInventory departmentProduction departmentThe company produces and sells table computers. As the economyis going down and other reasons, sales revenue did not achievethe target.“Customers might want better PC with new technology where thefirm is not able to adopt”, according to salesInventory is full of “out-dated” stocks which according to sales areobsolete.Production department still insist on manufacturing rather thancutting employees, saying that the current products aremarketable, just sales dept are not working hard enoughOwners of the company want to have normal profit as before, whichnot been achieve d for the last 3 quarters.
Definition: the extent to which individualfirms serve social needs rather than those ofowners and managers, even if this conflictswith the maximization of profits (Moir 2001)The firm might:Internalize social goalsRepresent concerns of groups other than owners andmanagersUndertake voluntary action beyond that required by lawRecognize the social consequences of economic activity.
Examples of expenditures on social responsibilitymight include:Charitable giving.Seconding staff to help with the management of communityprojects.Sponsorship of arts and sports, though at some point suchexpenditure might be regarded as advertising.And behaving in an environmentally responsible way by notpolluting rivers, etc.
Benefits for firm taking social responsibilities:Long-run self-interest of the firm: socially responsiblebehaviour generates additional revenue and profits in thelong run compared with firms that are less sociallyresponsible; this has been termed ‘‘winning by integrity’’.Stakeholders: it is beneficial to the firm to keep in line withethical, social and cultural norms, because this keepsworkers, customers and suppliers happy and minimizes therisks to the reputation and profitability of the firm.Regulation: bad corporate behaviour may lead to theimposition of an expensive and inflexible regulatory regimeto curb antisocial behaviour, while good corporatebehaviour may lead to the avoidance of governmentregulation and be a more beneficial outcome for the firm
1. Do you think “Bags of luck” likely to be anowner-controlled or managerial-controlledfirm? Explain your reasons2. Can you identify the objective (s) of Bags ofluck? Do you think all members of the firmhave the same set of objectives?3. Provide 3 solutions to help resolve thedifficulties facing Bags of luck. Ranking theimportance of those solutions