Unit 3: Business Objectives

Do all firms seek to maximise profits?


Students should understand that the models that comprise the traditional theory of the firm are based upon the assumption that firms aim to maximise profits. They need to understand the usual profit maximising rule (MC=MR). They should also understand the satisficing principle and know that firms have a variety of other possible objectives.

The conventional theory of the firm is built upon the assumption that businesses seek to maximise profits from producing an output and then selling it in product markets. Profits are maximised when marginal revenue equals marginal cost (MR=MC). The price, output and profits for a firm operating in an imperfectly competitive market (e.g. a monopoly) are shown in the diagram opposite;

In an exam you might be asked to consider and analyse how changes in revenues and costs might affect the profit maximising price and output. It might be worth drawing onto the diagram above to show the effects of a rise in demand and / or a fall in production costs. It is important to question the assumption that profit maximisation is the dominant objective in the day to day decisions of businesses in real world markets be they competitive or oligopolistic / monopolistic.


Why might firms depart from profit maximisation?

•Imperfect information about a firm’s demand and cost conditions – a business may not have enough information to accurately calculate marginal revenue and marginal costs. Often, pricing decisions are taken on the basis of “estimated demand conditions”. A business that is new to a market is unlikely to know the price elasticity of demand for a new product or the reactions of rivals to a change in price

•Alternative objectives of the managers of a business – managers, employees and shareholders within a large and complex business organisation may each have different objectives as stakeholders in a business enterprise. Much work for example in the new behavioural theories of the firm suggests that managers operating with some autonomy from the shareholders, might pursue strategies that depart from pure profit maximisation

For the exam you need to be aware of different objectives and also understand how this might affect the conduct and behaviour of a business operating in a market. Here are four different objectives:

•Satisficing:

Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit e.g. a target rate of growth of sales, or an acceptable rate of return on capital (a measure of profitability)

•Sales Revenue Maximisation :

Baumol argued that annual salaries and other perks might be more closely correlated with total sales revenue rather than profits. Revenue is maximised when marginal revenue (MR) = zero

•Managerial Satisfaction :

An alternative view was put forward by Williamson, who developed the concept of managerial satisfaction (or utility) achieved for example by success in raising a firm’s sales revenue, market share or meeting an output growth target

•Constrained Sales Revenue Maximisation -

Shareholders of a business may introduce a constraint on the decisions of managers. For example hey may introduce a minimum profit constraint designed to underpin the valuation of their shares and maintain a dividend.

No business is exactly the same – but there are plenty of reasons to believe that in the short-term a business may not be setting price at what it perceives to be a profit maximising level. In summary:
•Firm’s must consider the reactions of rival businesses to their decisions (especially in an oligopoly)

•Managers in a business will have freedom in setting price to suit local demand and competition

•How can multi-product firms hope to have enough information to profit maximise in every market?

•The strategies of a business evolve over time – profitability is important but so too might be the aim of surviving in a business during a recession, or an attempt to achieve market dominance by under-cutting rival firms for a time period, accepting that this will eat into profits in the short term

•Shareholders rarely have the day to day control of what managers are doing and the stock market is an imperfect instrument of controlling corporate performance

In our second diagram we show how a change in objectives (from profit maximisation to revenue maximisation) affects the price and output of a business. Think about how this affects economic efficiency and welfare (e.g. the balance between consumer and producer surplus).