"Discuss the assumption that the firm's main motivation is to maximise profits?"

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“Discuss the assumption that the firm’s main motivation is to maximise profits?”

The traditional theory (neoclassical) assumes that firm’s primary objective is to maximize profits. That is if the firm is owner controlled.  This assumption is based on that firms makes the output and price decisions. Also, that firm takes all necessary actions to earn the greatest profit possible. The managerial theory assumes firms do not necessarily act in order to maximize profits. The basic tenet behind this is the separation of ownership from management, complexity of the organisation and the firm’s manager maximizes his own utility and growth rather than profits. The reason for this is that managers may be judged by the level of sales revenue. I will be providing supporting arguments for and against this assumption “that the firm’s main motivation is to maximise profits” and draw a conclusion by analysing the firms behaviour as well as further discussing the theories of firms.

Profit maximising assumption is based on two premises, firstly that owner is in control of day-to-day management of the firm and secondly that the main desire of owners is to make a higher profit then the amount they invested in the firm. Since this assumption is based on two assumptions, therefore if these two premises don’t hold is it understandable to believe that firms goals is not to maximize profits. Well, this will depend on the motivation of individual firms.

If a firm’s ownership and control are in the hands of a single person or small groups of people, then it’s reasonable to assume that the firm’s owners’ goal is to maximize profits. But most of today’s firms are owned by shareholders and other large cooperation, but day-to-day control of the firm is under management. Therefore, the objectives of managements may differ from the shareholders and conflicts may arise. “For example Baumal (1959) suggest that the manager-controlled firm is likely to have sales revenue maximization, as its main goal than profit maximization favoured by shareholders” (Applied Economics 7th ed. p54). Also, studies of 177 firms between 1985 and 1990 by Conyon and Gregg (1994) found that the pay of top executive of large firms in UK was mostly related to sales growth.

Other studies have found that profit was the most important determinant of executive income. For example “A survey by Management Today in 1990 asserted that top executives pay was closely related to profit performance” (Applied Economics 7th Ed. p63). Again research by the US Strategic Planning Institute (Schoeffler, Buzzel and Heany 1994) indicates that in the short-run strategic planning support the idea of short-term sales revenue maximization by sacrificing profitability or growth. These studies also, found that there’s a link between market share and sales revenue. Market share had a significant and beneficial effect on both return of investment and cash flow, in the long-run. Hence, firms are seen as profit maximizers, as without sales revenue firms can not make profits, so it doesn’t matter whether the firm seeks to maximize profits or sales revenue end of the day profits is the difference between total revenue and total cost.  

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It is naïve to perceive that if a firm is controlled by the management then shareholders have no influence over it. For example shareholders can place constraint on managers at the annual general meeting “both Baumal and Williamson recognized that some constraint on managers can be exercised by shareholders” (Applied Economics 7th ed. p55). Therefore, shareholders can demand a certain amount of distributed profits from the firm, hence placing constraint on maximizing sales revenue. Another way shareholders can influence the objectives of the managers is by offering bonuses to management to meet the shareholders objectives.  

Studies by Marris ...

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