But its not only the agents at the bottom, Senior agents may also pursue their own objectives and utility functions and since they are the experts with the knowledge it is hard for the principal and the shareholders, to be sure that the managers are profit maximising.
This relationship can pose a danger; there is asymmetric information between the two sides. This means the agent knows more about the situation than the principal does (which ironically may be why the agent had been employed in the first place, for her/his specialised knowledge). The danger lays in the situation where the agent may not act in the principal’s best interest and may be able to get away with doing so because of the principals imperfect knowledge and inability to monitor effectively the day-to-day running of the firm.
This leads us onto how firms behave. The standard neo-classical assumption is that firms will always seek to maximise profits, that is they will strive for the largest possible profit by using its scarce resources as efficiently as possible.
However economists such as Simon (1957) would argue that bounded rationality may prevent individuals from being able to identify where the firm would be able to profit maximise. This is because there is too much information floating about and therefore it cannot be efficiently used. Cyert and March (1963) put forward that because a firm is made up of many different groups (shareholders, workers, managers) they will all have different utility functions and therefore not maximise profits.
Therefore if we go back to the principal-agent relationship and the problem of increased divorce and separation then it is unlikely that the firm will actually be in a position to maximise profits, the principal may think his/her firm is profit maximising. Especially if the firm has agents who pursue different goals from those of shareholders and therefore inefficiency is likely to occur.
Managers may be assumed to maximise their own utility, this may involve pursuits that contradict with profit maximisation. 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.
So why may managers wish to maximise sales revenue? One reason may be because managers, especially sales managers, may be judged according to a specific level of the firm’s sales. Sales figures are an obvious barometer of a firm’s health and therefore a managers’ power, prestige or salary may depend on this. In addition the firm’s sales representatives may be paid commission on their sales and therefore sales revenue maximisation may be a more dominant aim within the firm rather than profit maximisation, especially if there is a dominant sales department within the firm.
Baumol, in the 1950s, argued that because some managers salaries are linked to sales rather than profit naturally their incentive will be to maximise sales rather than profit, and therefore produce an output beyond what is required in the profit maximisation model.
£
TC
TR
Q
Qpm Qsr
From the diagram above we can make a comparative illustration of the difference in sales maximisation and profit maximisation. Sales revenue is maximised at the top of TR curve at an output Qsr, therefore for the given total revenue and total cost curves, sales revenue maximisation will tend to lead to a higher output and lower price than profit maximisation. Profit maximisation will be at the point Qpm, here the firm is producing less but charging a higher price.
The diagram above illustrates a more detailed relationship with between profit maximisation and sales maximisation.
If the firm’s minimum profit constraint is at level A, then the sales revenue maximising output level of level of Qs will provide sufficient profits. However if the firm’s required profit level if B then the sales revenue maximising output Qs is inadequate. The firm’s output would have to be lowered to level Qs* which is compatible with the profit constraint. Therefore we can see the higher the minimum profit constraint a firm has then the more important the constraint becomes, sales revenue and profit maximising (Qm) levels will be closer together.
The firm will have to start making sufficient profit to keep shareholders happy, in this case the firm can be seen to be operating with a profit constraint and therefore are profit satisficers. But if the firm is able to maximise sales and make a sufficient profit it may spend this surplus profit on advertising to increase revenue further. This would have the effect of shifting the total revenue curve upwards and also the total cost curve (since advertising costs money).
Sales maximisation tends to involve more advertising than profit maximisation. Ideally a profit maximising firm would advertise up to the point where marginal revenue of advertising equals the marginal cost of advertising, assuming diminishing returns to advertising. 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.
