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 (1964) found that there’s a consensus between shareholders and management is to maximize growth. The reason behind this is that management will seek power and status. Shareholders seek a growth in the capital value of the firm, which will increase their personal wealth. Since both manager and shareholder goals can be achieved through the growth of the firm. Hence, there’s no reason for firm to maximize profits, as growth of the firm increases capital and size of the firm. Besides firms are like big organisation with various groups, i.e. workers, managers, shareholders and customers, each of these individual have their own goals and will set their own goals. Today’s firms are complex than in the past and are more likely to have several objectives rather than just maximization of profits. For example behavioural theory assumes that firms actually operate under constraints imposed by organisational structures and the environment that they work in (Applied Economics 7th Ed. p57). Therefore, firm’s objectives may be to please everyone in their organization.
However, even if the firms operate under constraints they are still likely to set minimum acceptable level of targets, which are more likely to be achieved. If they successfully achieved these targets they will set another one, and gradually will arrive at the level of maximization of profits. Although growth of firms is an important factor it is not favourable than higher profit. This is because faster growth doesn’t necessarily mean higher profit, because firms have to spend some of its revenue if not all. Recent analysis by Strategic Planning Institute (Buzzel and Gale 1987) shows there’s an inverse relationship between market size and the rate of returns on investments (Applied Economics 7th Ed. p66). This implies that shareholders and investors wouldn’t risk their deposit, if the firm that they invested doesn’t give them a greater return.
For firms to maximize profits they must have detailed knowledge of marginal analysis, where marginal cost (MC) equal marginal revenue (MR). However, marginal analysis doesn’t tell us how to maximise profit but it simply tells us what the output and the price must be (Applied Economics 7th Ed). Moreover, to reach marginal analysis firms need information, on their consumers, their demand curve, the amount they produce and what price to sell their goods. In reality many of them will not have sufficient funds to spend on collating information alone. Nevertheless, firms do carry out market research on their targeted consumers. They also, have to decide the time period over which the firm should seek to maximize profits. The markets where the firms works constantly changing “firms operate in a changing environment” (J. Sloman. p195). Therefore, firms are unable to predict the market behaviour, hence, cannot set specific targets. Another example is when the firm should decide to replace its ageing equipments. If it does, its short-run cost will rise and its short-run profits will fall. But, by investing in new equipments quality of the product may increase, consequently resulting in hire demand in the long-run and hence maximizing profits (Sloman, J 2003).
Profit maximizing firms tend to produce less output than the sales revenue maximizing firms and are able to set prices. The reasons being that firms’ are in business to make profits and they will economise on their transaction costs. When the transaction costs of firms are low they work best and when the transaction costs are high, there’s an incentive for the firms to reduce its cost by producing less or carrying out fewer transaction or by charging a higher price (Priciples of Economics 9th ed. p117). But, it is not always best to charge customers high prices as they are likely to switch to competitors.
Hence, by charging the highest possible price is often a poor way to maximize profits. Successful companies maximize their profits by minimizing their costs. This is the case, because firms would exploit every possibility to maximize profits. For example majority of high profitable corporate companies, produce a lot and yet increase profits because, they innovate in production by consistently producing efficiently and they take great care when allocating resources in their projects. As a result their costs of productions fall and profits increases.
In order to maximize profits, a firm needs to be aware of the market structure where it does business. Revenues are a function of sales and the price the goods or services are sold at. The greater the price per unit sold, the higher the revenue and potential profit However, current markets are far more competitive, therefore a firm may have only a moderate degree of control over prices. Even some of the most successful firms with a huge market share face price competition. For example, Intel makes the CPU (central processing unit) chips (e.g. the Pentium) that are found in almost all personal computers.
Although Intel has nearly a 90% market share (William, K, Objective) in CPUs sold in new PCs, it still faces competition. Since products made by competitors such as AMD are seen by PC manufacturers and consumers as close substitutes for Intel's chips, Intel must maintain prices at a competitive level or risk losing a large amount of market share. In fact, Intel regularly cuts the prices of its products (usually by about 25% each quarter of the year). If instead, Intel tried to maximize its short-term profits by charging significantly higher prices for its CPU chips; its market share would quickly erode. Regardless, Intel is one of the world's most profitable companies and its stock price has consistently increased during the past decades (William, K, Objective).
In a major study by Shipley (1981), concluded that only 15.9% of his samples of 728 UK firms were regarded as true profit maximizers (Applied Economics 7th Ed p60). The conclusion reached here by cross-tabulating responses to two questions, shown on the table with the results.
Source: Shipley (1981).
The results is so small because, many firms may not consciously see themselves as profit maximizers, as most of them don not specifically set out to maximise profits. But it is seen as a significant factor in decision-making “(Hilton (1978), in reviewing a series of reports by chairman and employees in published UK annual accounts, concluded that profits is clearly regarded as a major objectives by employer and employees alike” (Applied Econcomics 7th Ed. P62). In addition to this, traditional theory assumes that firms invest in most profitable project first and so on. E.g. marginal cost equal marginal revenue. However, choosing a project is a complex process. Firstly firms may not have sufficient funds to cover the cost and secondly projects are undertaken by educated guess on how the market may react in the future. But, most often than not firms set minimum rate of returns from the projects they undertake. Therefore, setting the returns rate is seen as profits maximization.
Despite the growing importance of non-profit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy. Profit is defined as revenue minus cost, that is, as the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output. Therefore, in practice profit maximization is desired in the long-run, if not in the short-run.
The traditional theory of the firm assumes that its sole objective is to maximize profits. The other managerial theory assumes that where ownership and control of the firm is separated. The objective of these types firms will be those set by the managements. According to the short-run theory the firms favours sales revenues over profits, even though profit maximization is part of the goals. Research by the Strategic Planning Institute found that without the short-run sales revenue there will not be any long-term profit. Here, sales revenue is seen as paramount to long-term profits and survival of the firms. In the long-run viability of non-profit maximiser would find it very difficult to compete with other firms in a free market. As Alchian (1950) explicated that in the long-run, natural selection would results in the survival of the profit maximizers, as well as Friedman (1953 p21-22), argued that regardless of how actual firms may behave and constraints on rationality they may be subject to, the surviving firms are those who attained high profits. Due to the strength of these arguments, we tend to accept profits maximization theories are justifiable.
Bibliography
Alchian, A (1950), “Uncertaintity. Evolution, and Economic Theory”, Journal Of Political Economy. 58(3), 211-221.
Buzzel, R, & Gale, B. (1987). The PIMPS Priciples, Strategic Planning Insitute.
Conyon, M & Gregg, P. (1994). Pay at the top: a study of the sensitivity of top director remuneration to company specific shocks, National Institute Economic Review, August.
Friedman, Milton (1953), Essay in Positive Economics, Chicago: Chicago University Press.
Griffith, Alan & Wall, Stuart (1997). Applied Economics: An Introductory Course. 7th Ed.
Lipsey & Chrystal (1999). Priciples of Economics. 9th Ed.
Marris, R. (1964) The Economic Theory of Managerial Italism, Macmillan.
Sloman, J (2003).”Economics”. Prentice Hall. 5th ed
William, K. “Objectives”. Can be found on:
http://william-king.www.drexel.edu/top/prin/txt/MPch/firm2.html. Accessed 4th of February 2005.