THE OBJECTIVES OF
FIRMS
The Firm’s
Objectives
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Lesson Objectives
 Appreciate that firms, in addition
to profit maximisation, have a
range of objectives that they
endeavour to satisfy
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Connector
In pairs explain the following terms:
• Profit-maximisation
• Normal profit
• Supernormal profit (Abnormal profit)
• Subnormal profit;
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Big Picture
• We will challenge the concept that firms
exist to maximise their profits and we will
use other terms such as ‘satisficing’ to try
to explain the real-world behaviour of
firms.
• It is in this area that economists are able
to draw on the empirical evidence that is
more the prerogative of business and
management studies.
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Big Picture
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To arrive at the learning outcomes you will do the following:
Listen to teacher demonstrations on PPP
Draw graphs
watch VIDEO
‘Stretch and challenge’ Questions
Group work
Independent work
Class discussion
Short presentation
Demonstration on the board
Pair marking
Advise on examiner’s tip
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Lesson Outcome
 Appreciate that firms may have a diverse
range of objectives
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Key Terms
• Public Limited Company
(PLC) ;
• Corporation ;
• Director ;
• Perks;
• Dividends;
• Share options;
• Annual general Meeting
(AGM);
• Activist shareholders;
• Hostile bid;
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Stisficing;
Shareholders;
Carbon footprint;
Corporate citizenship;
Market share;
Market power;
Rational choice theory;
Capital market discipline;
Delisting;
Innovation.
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A Firm’s
Objectives
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A Firm’s Objectives
• The traditional theory of the firm argues that the firm’s sole
objective is to maximise its levels of profits
• And suggests that an entrepreneur will change levels of
output every time there is a change in the levels of prices or
costs.
• However, in a world concerned about negative externalities
and the destruction of the environment, a firm that ignored
these considerations in order to increase its profit levels
would be likely to lose custom and receive heavy censure.
• Thus is shown in the case study below.
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Case Study – page 20
‘We Blew it’ – Nike admits to mistakes over
child labour
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A Firm’s Objectives
• The theory of profit maximisation can be
criticised and challenged on a number of
grounds and a number of competing
alternatives have been advanced.
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The Divorce of Ownership and Control
• Individuals who own their own firms may be extremely keen
on profit maximisation
• But in large firms there is a gap between ownership and
control.
• Shareholders who own the firm, want to maximise their
returns – profits and keep cost low, but are not in position to
run the firm.
• Shareholders appoint directors to represent their interests
and directors appoint managers to run the company.
• Professional managers are given control and the interests of
managers may be different from that of the shareholders.
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The Divorce of Ownership and
Control
• Directors and managers salaries are determined
more by the size of the business than the profitability
of the firm
• This may colour their actions and they may seek
market size in terms of its output, sales and
employment rather than profitability.
• This would suggest that the sales growth will be an
important objective of the board of directors
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Satisficing
• Means the firm is producing satisfactorily but not maximum
profit.
• Firms are more likely to satisfice than maximise, that is,
they will make what is acceptable and satisfactory rather
than achieve the optimal solution.
• This means that the firm will make sufficient profits in
order to keep shareholders happy but will not waste time
and resources seeking the optimal solution.
• A firm that is satisficing may produce a range of outputs
that are within its target level of profits rather than the
specific profit-maximising output.
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Satisficing
• A profit maximising firm will
produce at the output that
maximises profits, Pmax,
giving an output of OB.
• A satisficing firm that does
not want to make a smaller
profit than that of Psat has
a range of possible outputs
between 0A and 0C.
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Social Responsibility
• Some large firms now include ‘social responsibility’ among
their objectives,
• Which means they pay due regard to the needs of the
stakeholders of the business – employees, customers and
even national targets, such as reducing their carbon footprint.
• These so-called activities of corporate citizenship are likely to
increase the firm’s costs and so reduce its level of profits.
• However, some stakeholders argue that such caring activities
do not always conflict with profit maximisation.
– E.g. good staff are easier to attract and retain by firms that are seen as
socially responsible, and this reduces the costs of staff turnover.
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Sales Maximisation Theory
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Sales Maximisation Theory
• Suggests that managers want the firms they work for
to be as large as possible
• As working as a high level manager for a very large
corporation is an extremely prestigious position.
• Managers may be receiving sales-related bonuses
and,
• In this case, the manager might increase sales up to
the point where MR is zero and TR is maximised.
• This would be at the output of 400 units in Figure2.2.
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Sales Maximisation Theory
• This would be at the output of 400
units
• And as Marginal Costs are more
likely to be positive than zero, the
firm will not be maximising its
profits by producing where MR =
MC but maximising its sales
revenue,
• And this will reward managers
rather than shareholders who
would benefit from profit
maximisation.
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Sales Maximisation Theory
• A further argument is that sales are the key to
market share and possibly market power, and
that growth is the key to future profits and
managerial security.
• Managers may be reluctant to undertake
short-term risky ventures, even if the profits
are large as failure to achieve success could
terminate their careers.
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Inability to Profit Maximise
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One of the problems faced by a profit-maximising firm is the assumption that firms
have complete information about the costs and benefit of each option and they
compare the options and then make a rational choice.
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The rational choice theory is can be unrealistic and that firms lack the information
to make the choices that profit maximisation suggests.
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In order to set prices, a firm needs to know its marginal cost of producing the
good, as well as the elasticity of demand – how responsive customers will be to
changes in prices.
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In practice, real-world firms are typically very complex, produce multiple goods,
and detailed information on marginal cost is rarely available.
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These factors make it almost impossible for a firm to make accurate assessment of
whether it is profit maximising.
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In addition, there is likely to be a natural time lay between accumulating and
processing information, which means that important decisions may be made too
late to maximise profits.
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Organisational Theory
• According to profit-maximising theory, firms will choose an
output and price that is the most profitable.
• Organisational theory stresses that in large firms, decisions
are made after much discussion by groups and committees
and once they are agreed and adopted they are changed only
reluctantly.
• Organisational theorists suggest that satisficing will take place
as the organisation pursues a number of goals, such as
increasing their market share or levels of sales.
• Profit maximisation is not then the major driving force of the
firm, so an output could be chosen that ensures that the
product will achieve market penetration rather than
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maximum profits.
Cost Plus Pricing
• This approach argues that firms follow a policy of
non-maximisation by choice.
• They pursue a policy which is known as full cost
pricing.
• In this theory the firm sets its price equal to average
cost, at normal capacity output, plus a conventional
mark up.
• So the level of prices is the level of average costs
plus, e.g., 25%, which is the conventional mark-up
(level of profits) for the industry.
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Cost Plus Pricing
• This Figure shows the long-run average variable
cost with the minimum efficient scale at 0A.
• Between 0A and 0B the firm experiences
constant returns to scale.
• The cost plus view is that firms will produce
somewhere between 0A and 0B and add a
mark-up up when LRAVC changes.
• In this situation firms only change their prices
when their average costs change substantially
as a result, e.g., of an increase in the cost of raw
materials
• But do not adjust their output to maximise
profits along the lines suggested by the
traditional theory.
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Long-run Profit Maximisation
• The neo-classical theory of the firm suggests that firms will react to every shift
in market and alter their price and output accordingly.
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In reality this is unlikely to happen for a number of reasons,
• If supply falls firms may avoid increasing prices too rapidly for fear of losing some
brand loyalty due to their perceived avaricious behaviour.
• For large firms the costs of continually changing brochures and price lists is likely to
outweigh the benefits, unless large changes in market conditions occur.
• This has led to the development of the concept of long-run profit maximisation
as an attempt to explain firms’ behaviour.
• The suggestion is that sales are the key to growth and growth is the key to
future profits and managerial security.
• Firms will not attempt to increase short-run profits by undertaking risky, even if
profitable ventures, as long-run profitability requires survival, and survival may
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require caution.
Company Size
• Profit maximisation suggests that all
companies will react in the same way and this
is not borne out by observations in the real
world.
• We have to accept that a small
entrepreneurial company is likely to respond
differently to a huge multinational that has a
range of different objectives.
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In Conclusion
• Profits are very important to a firm and firms are strongly
motivated in the search for profits and prefer to make more
profits rather than less profit.
• There is pressure to make large profits in the short run to
keep shareholders happy an to maintain the price of the
company shares.
• At present any acceptable theory is likely to be profit
oriented, especially in the short-run, because if the firms’
managers fail to make the profit their assets can achieve, they
will be subject to a takeover bid by other firms that think they
can use the assets more successfully.
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In Conclusion
• The pressure of takeovers is likely to limit the discretion of the
managers to pursue other goals than profits.
• Such short-term behaviour may be to the detriment of the
company’s long-run aims as it may preclude capital
investment,
• Which, in the short run, would be extremely expensive and
reduce profits but could prove to be extremely profitable in
the long run.
• Some companies like virgin have delisted their shares in order
to remove such short-run pressures.
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http://www.youtube.com/watch?v=Jjj
vQSmeWGQ&feature=related
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The various objectives that a business might have
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Examiner’s Tip
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Activity – page 24
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Answers
1.
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2.
3.
Reasons could include:
concern over negative externalities
extremely complicated business making it difficult to accurately
calculate the profit-maximising level of output
directors’ salaries could be linked to the size of the business and market
share, rather than profits
firms could seek to maximise market power, which may reduce profits
in the short run but could lead to higher profits in the long run
difficult in practice to continually change the level of output in order to
maximise profits as it may mean that workers have to be laid off and
then reemployed, which is difficult.
Total revenue is maximised when marginal revenue is zero. For profits
to be maximised at this point, marginal cost would also have to be zero,
and this is not possible. Students could draw a variety of diagrams, such
as the relationship between TR and MR, or a graph showing AR, MR, MC
and AC, indicating the revenue-maximising and profit-maximising
points.
A public limited company (PLC) is a firm owned by a group of
shareholders, and whose shares are traded on the stock exchange.
People buy shares in order to maximise their returns, that is, their
dividends (share of profit), so shareholders want profit to be
maximised, which doesn’t necessarily occur at a point where average
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costs are minimised.
The objectives of firms
Innocent’s objectives
Learning objectives:
 appreciate that in addition to profit maximisation, firms often have a range of other objectives that
they want to satisfy
 understand that firms can grow in different ways.
Scenario
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Innocent Drinks make smoothies, juices and ‘veg pots’, and are characterised by their ethical slant on
everything what they do. At just 10 years old, Innocent now has a total revenue of around £100m.
The Innocent ‘ethos’ is built around the four main principles advocated by its founders:
 ethical purchasing
 reducing/offsetting carbon emissions
 recycling
 charitable giving.
These principles govern every decision made, from recruitment through to the purchasing of bananas and
advertising campaigns.
Richard Reed, one of Innocent’s founders, has said that ultimately, Innocent’s objectives are to do with
growth and profit. Some might think that Innocent’s ethical stance would cause these objectives to
suffer. However, many consumers buy Innocent products over the alternatives because of their inbuilt
ethical approach, allowing them to feel like ‘do-gooders’. So, Innocent’s employees have to be both
commercially minded, and altruistic – not an easy combination to find!
For the moment, Innocent’s founders are pursuing expansion in the European market, but are to work on
global expansion when the time is right. As yet, there is no clear way forward; Adam Balon, one of the
original founders, recently said that a sale of the company, a partial issue of publicly traded shares or
simply continuing to grow organically were all options being considered. Achieving internal growth,
however, is becoming more difficult as Innocent’s founders are having to delegate responsibilities, such
as marketing and recruitment, that they have previously handled themselves.
Questions
1. Explain what is meant by ‘total revenue’.
2. Examine the importance of profit for companies.
3. Using examples from the case study, and your own knowledge, outline other possible objectives that a
company such as Innocent Drinks might adopt.
4. Outline reasons why achieving organic growth can be difficult for a company such as Innocent.
45 to
5. Comment on the statement that ‘expansion via the sale of Innocent is the best way for the company
grow’.
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AQA Examination-style questions, page 28.
Data response question 1:
a)
Marginal in economics refers to small increments. Many large
companies would not be interested in the ‘marginal’ mines
because it would incur significant cost to generate any revenue,
that is, it would be small part of their overall profit. However, for
a small company, such mines could generate enough profit.
b)
Diagram should be similar to that shown in figure 09 from
Chapter 2 of the student book. New technology would allow
Petra to benefit from lower LRATC than De Beers; so, if costs are
lower then profits are likely to be higher.
c)
Define market share – relate it to De Beers previous strategy (that
is, own as many diamond mines as possible). Explain why ‘higher
returns’ (that is, higher profits) may be sought by De Beers (that
is, profits provide funds for further investment, shareholders like
high profits as it leads to higher dividends, reward for being
entrepreneurial, etc.). Discuss advantages and disadvantages of
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two or three other objectives.
Essay question 2:
a) Reasons include:
 Reduces competition.
 Strengths: less expensive to compete, higher brand loyalty.
 Weaknesses: could encourage investigation by Competition
Commission, could take advantage of market position and raise
prices (thus reducing consumer surplus).
 Control can be gained over companies further back/forward in the
production process.
 Strengths: greater reliability of raw materials (delivery times,
quality, prices, etc.), reduce sources of raw materials for
competitors.
 Weaknesses: diseconomies of scale and miscommunication
possible.
 Leads to higher profits.
 Strengths: benefit from economies of scale thus reducing costs,
greater availability of funds for investment.
 Weaknesses: pay higher corporation tax, could take time for
increased market share to lead to higher profits.
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Essay question 2:
b) Internal growth:

Plough-back profit.
 Issues to consider: reduced dividends for shareholders, depends on market
interest rate (might be wiser to save), less risky than taking out a loan, small
companies often have small profits so not much money available for investment
in this way.

Borrow funds.
 Issues: costs of financing could be unmanageable if interest rates change, less
impact on shareholder dividends, easier for small businesses to borrow than use
profits but often penalised with higher interest rates than larger, established
companies.
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Innovate/invent.
 Issues: not an easy or predictable thing to do, small companies may lack expertise
to take new ideas to market, can lead to rapid growth if the idea is good, leads to
imitation.

External growth (mergers/acquisitions).
 Strengths: speedy, can be financially rewarding if there’s potential for asset
stripping, reduce competition, gain new brands without investing in marketing,
can be cheaper than internal growth.
 Weaknesses: could end up with diseconomies of scale, poor communication, poor
culture fit between companies (especially if done very quickly), may be done for
wrong reasons (satisfy egos of managers rather than for good business sense). 49