Student Number: 0117602
01/11/2001
Is ‘profit maximisation’ a satisfactory assumption when
modelling the behaviour of firms? Why?
Economists have traditionally assumed that firms want to maximize profits. But do
firms necessary want to maximize profit? When we attempt to establish what the
objectives of firms might be, the distinction between managers and owners is crucial.
This essay looks at the role of firms in the economy. Section one explains how firms
are concerned to use inputs to make outputs and how managers analyse their choices
in order to make profits. Section two talks about the role of the firm and its
organisational structure whereas section three deals with profit maximisation theory.
On section four and five is a contrast between long-run and short-run profit
maximisation. Section six deals with relation between profitability and the growth of
the business and the last section gives some conclusions about different alternative
theories when we modelling the behaviour of firms.
Firms will normally wants to make as much profit as possible. By thinking to
maximise profit, the firm could fulfil the human wants, which are defined as scarcity.
Firms are concerned to use inputs to make outputs, which it means to spend money in
order to make money because inputs cost money and outputs make money then the
difference between them gave the profit. In order to stay in business firms will do
what they can to avoid a decline in profit. But to achieve these objectives managers
need to make choices. They need to decide out type of output to produce and at what
price? What technology to use and what number and type of workers to employ? To
be successful and at least not to decline the profit, firms need to analysis these factors
into political, economic, social and technological (PEST), which will help to establish
a strategy.
As it is stated on Economics for Business (Sloman, J and Sutcliffe, M, 2001) most
production decision are not made by individuals who will consume the product but by
the firms. So the firm is an economic organization that coordinates the process of
production and distribution. Firms were seen as simple organization that produce
output by employing inputs, and no attention was paid how they were organized and
how they would influence their behaviour. The legal structure of firms have
subsequent performance within the market place and there are several types of firms.
Organizational structure of the firm leads to the success of a business organization.
Firms are organized internally in different ways, which it is depends on their size.
Large firm’s organisational structure is more complex than small firms. As firms
grow they tend to move from centrally managed into separate departments, such that
responsibility is separated from the formulation of the business strategic plan.
Economists have traditionally assumed that firms want to maximise profits. As
quoted on Economics for Business (Prentice Hall, 2001) this theory have been
criticized mostly for two reasons for being unrealistic. First one is that firms may
want to maximise profits but they are unable to do so or firms may have aims other
then profit maximisation. Shareholders and managers think different about profit
maximisation. Owners of the firm may want to maximise profits. By referring on
(Economics for Business, 2001) the twin process of managerial expansion and
widening share ownership led Berle and Mains (The Modern Corporation and Private
1
Student Number: 0117602
01/11/2001
Property, Macmillan, 1933) to argue that the ownership of joint-stock-company no
longer meant control over its assets. So, the business has grown nowadays and
modern companies are legally separate from their owners, it will be the person or the
group in charge of the business (in this case managers) to make decisions.
Managers may have different ideas about profit maximisation. They may want to
maximize their own interests for example to maximize their own utilities, higher
salary, greater security, greater sales, better working conditions, greater prestige or
popularity with their subordinates. By having other aims rather than profit
maximization, conflicts could be developed between managers and shareholders. To
avoid this conflict, managers need to ensure that sufficient profits are made. The
sufficient profit is the target level of profit that managers strive hard to achieve in
order to keep owners happy.
By referring to the Financial Times newspaper (October 18, 2001) about profit
warning focused on Financial Times Group, the sufficient profit for them was last
year’s profit. After a drop in advertising revenue the owner of Financial Times told
investors that profit will be below expectation. This is a case that they want to
maximize their profits in the long run. Some firms may chose to maximise profits
over a long time period. If the firm becomes larger with a larger share of the market,
the economic power may help the firm to make more profits in the long run. But in
the long run profit maximization, the prices and outputs can not be calculated
precisely.
Managers’ salaries, power and prestige may depend on sales revenue. The success of
managers may be judged according to the level of the firm’s sales. So, managers may
aim to maximize the firm’s short-run total revenue. This is an alternative theory,
which it is called sales revenue maximization and it is easy to identify the price and
output that meet this aim.
Also, profitability is related to the growth of the business. The more profit a firm can
make, the more access to the cheap finance a firm can have, which it leads to more
investment and growth of business. Firms may want to grow but it might not be
possible because of several factors that can restrict the ability of business to expand.
Growth above a certain rate may be at the expense of profits. Some firms may want
to maximize profit rather than business growth. But in order to remain in the market
place, they may be forced to grow.
When modelling the behaviour of the firm, there are different alternative theories.
Some firms may think to grow their business whereas others may think to maximize
their profits. Owners and managers may have different thoughts about profit
maximisation and this theory has been criticized for two major reasons. Also, if sales
revenue maximization has a dominant sales department, it may be a more dominant
aim in the firm than profit maximization. Other alternative theories of the firm
assume that, large firms aim for a target level of profit rather than absolute maximum
level, so they are called profit satisfiers.
2
Student Number: 0117602
01/11/2001
Bibliography
Sloman, J and Stcliffe, M (Printice Hall, 2001) Economics for Business
Newspaper (08/10/2001) Financial Times
Adolf A, Berle and Gardiner C, Means (1933) The Modern Corporation and Private
Property as quoted on Economics for Business (Printice Hall, 2001)
3