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Does the existence of the principal-agent relationship within the firm contradict the assumption of profit maximisation?

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Introduction

Does the existence of the principal-agent relationship within the firm contradict the assumption of profit maximisation? This essay will be looking into the whether the existence of the principal-agent relationship within the firm contradicts the assumption of profit maximisation. One of the features of modern complex firms is that principals (owners) have to employ agents (managers/workers) to carry out certain duties within the firm. Workers are agents of management, junior managers are agents of senior managers, senior managers are agents of directors, who themselves are shareholders. From this we can see that in large firms there is often a complex chain of principle-agent relationships. The need for agents could be for many reasons for example the firm may be too large for the principal to manage on his/her own, and as a result require many levels of managerial hierarchy in order for it to run effectively. Or it could be because the principle may wish to employ an agent who has specialised knowledge in a certain area, such as managerial, accountancy or marketing skills. This specialised knowledge in turn will save the principal a great deal of time and effort. ...read more.

Middle

These could be higher salaries, greater power, prestige, better working conditions or greater sales. Different managers within the same firm may well pursue different aims. Managers will still have to ensure sufficient profits are made in order to keep shareholders happy, but that again is still very different from actual profit maximising. Because managers of the firm may have alternative objectives it can be said they are profit satisficers, this means managers may strive hard for minimum target level of profit, but maybe less interested in profits above this level. Managerial theories have also been developed around this, they would suggest that managers may maximise a different variable subject to a profit constraint, they are able to do this because of the freedom they enjoy because of lack of monitoring. The conflicting objective pursued by the managers could be sales maximisation. This is when managers aim to maximise the firm's short run total revenue. This concept was originally developed by Baumol in the late 1950s. With the theory of sales maximisation it is easy to identify the price and output that meet this aim, unlike profit maximisation. With sales maximisation firms would produce more and sell at a lower price than at profit maximisation, which is good news for the consumer one could argue. ...read more.

Conclusion

But the firm aiming to maximise sales will go beyond this since further advertising, although costing more than it earns the firm, will still add more to total revenue, the firm here would continue advertising until all surplus profit above the minimum are used up. How can the problem of the principle-agent relationship be overcome to ensure profit maximisation? Ways to do this is to offer incentives to agents based on individual output, possibility of promotion according to the pursuance of the right utility function, profit sharing executive schemes, and piecework schemes. These types of incentives help to focus the goals of all agents on profit maximisation, reducing the principal agent problem. In conclusion this essay has looked into whether the existence of the principal agent relationship contradicts the assumption of profit maximisation. We can see that because of the relationship alternative strategies can be developed by agents, this may stem from their individual utility function or from the culture of the firm, i.e. if it has a dominant sales department where the level of sales is important. However this can be overcome simply by either close monitoring, which may not be very cost effective for the agent, or by giving agents greater incentives to ensure their objectives are in line with the principals and shareholders. Armandeep Padda Microeconomics (Business Economics) Seminar Group F - 1 - ...read more.

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