Unit 3

Kno-how! on motives for firms

3.1 Objectives & 3.6 Profit

Students should be able to: Distinguish between different corporate

objectives and exemplify these diagrammatically

Understand the distinction between normal and supernormal profit

Explain and illustrate the concept of profit maximisation using MC and marginal revenue

3.1 Objectives & 3.6 Profit

Background Reading: Nutter A2 micro book (2nd ed) p. 27- 32 Student Unit Guide (Old ed / New ed)

p.24-27 / p.15-19

Motives of Firms

Profit maximisation

Profit Maximisation

Profit maximisation – assumed to be the standard motive of firms in the private sector

Profit maximisation occurs where Marginal Cost (MC) = Marginal Revenue (MR)

The firm will continue to increase output up to the point where the cost of producing one extra unit of output (MC) = the revenue received from selling that last unit of output (MR)

Profit maximisation diagramCost/Revenue

Output

MR

MR – the addition to total revenue as a result of producing one more unit of output – the price received from selling that extra unit.

MC MC – The cost of producing ONE extra unit of production

100

Assume output is at 100 units. The MC of producing the 100th unit is 20.

The MR received from selling that 100th unit is 150. The firm can add the difference of the cost and the revenue received from that 100th unit to profit (130).

20

150

Total added

to profit

If the firm decides to produce one more unit – the 101st – the addition to total cost is now 18, the addition to total revenue is 140 – the firm will add 128 to profit – it is worth expanding output.

101

18

140

Added to total profit

30

120

Added to total profit

The process continues for each successive unit produced. Provided the MC is less than the MR it will be worth expanding output as the difference between the two is ADDED to total profit.

102

40

145

104103

Reduces total profit by this amount

If the firm were to produce the 104th unit, this last unit would cost more to produce than it earns in revenue (-105) this would reduce total profit and so would not be worth producing.

The profit maximising output is where MR = MC.

Profit maximisation

Output

Price & Cost

AR

MC

AC

MR

P1

AC

Q1

Profit maximisation

The traditional maximising goal assumes that owners control the

management of the business requires sufficient and accurate

knowledge of cost and revenue conditions in the market so that MR and MC can be found

This neo-classical assumption of all firms behaving in a manner that seeks to maximise profits is now questioned

Alternatives to profit maximisation

1. Share price maximisation

Share price maximisation: Pursuing policies aimed at increasing the share

price

2. Revenue maximisation

Total Revenue =

Average Revenue =

Marginal Revenue =

Revenue maximisation occurs where MR becomes 0 and therefore TR is maximised as in the following diagram at MR = 0.

Revenue maximisation

Output

Price & Cost

AR

MC

AC

MR

P2

AC

Q2

3. Sales maximisation

Sales maximisation is achieved when AC = AR which is beyond the output which maximises profits but where the firm earns ...

... normal profits, where AR = ATC as this ‘break-even’ point is where all costs are being covered including the opportunity cost of the entrepreneur which is their potential pay as an employee doing a similar job.

Any output beyond this incurs a subnormal profit and therefore ...

Normal profits

Output

Price & Cost

AR

MC

AC

MR

P3=AC

Q3

Costs

Output (Q)

Different output levels - test

ATC

AR (Demand)

MR

MC

A B C D

Costs

Output (Q)

Different output levels - answers

ATC

AR (Demand)

MR

MC

A B C D

A= profit max

B=productive efficiency

C=rev max

D=sales max (all. eff)

4. Social entrepreneurship

A social enterprise is a business that has primarily social objectives whose surpluses are reinvested for that purpose in the business or the community, rather than being driven by the need to seek profit to satisfy investors.

A social enterprise is looking to achieve social and environmental aims over the long term.

They may be profit seeking – but it is what they do with their profits that makes the difference

Examples of social enterprises

Café Direct Fair Trade Traidcraft Divine Chocolate Eden Project Housing Associations Fifteen Foundation Fair Finance First Fruit Greenwich Leisure Brentford FC or Exeter FC Big Issue

Minimum (normal) profit constraint

Why is minimum profit necessary? Desire to receive an acceptable distribution of

company profits from interim and final dividends Dilution of profits may have a negative effect on the

company’s share price on the stock market In this way the stock market acts as a check on the

behaviour and performance of each quoted company Opportunity cost

Sales maximisation, revenue maximisation or social entrepreneurship takes profits below their maximum level. Thus social entrepreneurs are less likely therefore to be plc’s.

Stakeholders & aims Stakeholders are groups who have an interest

in the activity and performance outcomes of a business, eg Shareholders Managers Employees Suppliers Customers Government and local communities.

Eg in public limited companies, ownership and control are separate: owners seek maximum profits; managers may seek sales maximisation as these increase their bonuses.

Modern firms have to attempt to match competing stakeholder needs

Stakeholder objectivesFirms may have to balance out their stakeholder

responsibilities because different stakeholders tend to have different objectives and therefore may come into conflict:

‘Fat cat pay’ & management rewards – bonuses

v social and environmental audits

v employee welfare & high wages

v meeting consumer needs esp low prices

v paying suppliers on time

v satisfying shareholders (owners) (‘The City’), who want (maximum?) profits (> large dividends or share price growth), about its policies, plans and actions.

Divorce between ownership & control

The majority of shareholders in a plc cannot exercise day-to-day control over the decisions of managers

Managers employed by a business may have different motivations than owners, they may want to maximise their own utility from being in charge of a business

This may lead to decisions that are not consistent with profit maximisation / or maximising shareholder value over time

Ownership and control

Principals:Shareholders

Control Mechanisms:Pressures from the stock marketRegular meetings with shareholders (AGM)Performance related pay (to provide incentives)

Agents:Board of DirectorsSenior Management

OWNERSHIP

CONTROL

Managerial Discretion Models

The divorce of ownership from control has lead behavioural economists examine the decisions that are taken within complex business organisations.

Managers may have discretionary powers in deciding on price and output and marketing in different segments of markets

Much depends on the degree of autonomy (freedom) that the head office of a business gives to its managers employed in individual sales outlets

Divorce of ownership from control leads to the principal agent problem with maximising behaviour may be replaced by satisficing.

The principal agent problem

The principal (shareholder), hires an agent (manager) to perform tasks on his behalf but cannot ensure that the agent performs them in exactly the way the principal would like. The efforts of the agent are expensive and

time-consuming to monitor Incentives of the agent may differ from those

of the principal leading to a conflict of objectives

It is linked to the problem of asymmetric information Unequal information share between two

parties It does not arise if a legal contract can be drawn

up to specify all the duties of the agent

Coping with the principle agent problem

Have the right incentives!

1. Share-ownership schemes

2. Performance-related pay

(a) Incentive pay schemes e.g. profit sharing

(b) Wages and salaries related directly to productivity / profitability

3. Long-term employment contracts for senior management – to give them a higher degree of loyalty to the business

4. Generous non-financial rewards but based on / contingent on assessments of performance

5. Regular performance reviews

Ownership, control & influence

Principals:Shareholders

Control Mechanisms:Pressures from the stock marketRegular meetings with shareholders (AGM)Performance related pay

Agents:Board of DirectorsSenior Management

OWNERSHIP

CONTROL

INFLUENCEOther influences on business behaviour:Consumers – e.g. ethical retailingIndustry regulatorsGovernment (taxation, trade policy etc)

Most people and businesses SATISFICE!

5. Herbert Simon & (profit) satisficing

Profit satisficing: Generating sufficient profits to satisfy

shareholders but maximising the rewards to the managers / board and avoiding attention from rivals or regulatory authorities, ie setting minimum acceptable levels of achievement

Satisficing = Satisfy + Suffice. No business can process all the factors

affecting the marketing / pricing of a product, in the hope of maximising profit.

Herbert Simon & (profit) satisficing An example of “bounded rationality”

because the complexity of decision-making may lead to managers following “rules of thumb” rather than seek optimal decisions all of the time.

Agents (e.g. managers) face information costs in the present and uncertainty about the future

This limits their decision-making ability and may force them to make decisions by seeking the first satisfactory solution rather than optimizing