1a kno how on motives for firms
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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