If firms were not in a competitive environment, they would be able to control the market. Still, there are other factors, which stop firms from controlling the market. Namely the fact that firms do not have perfect information, issues about its objectives or firms may not even know how to maximise profits. This is due to the fact that companies use different pieces of information or interpret it differently.
Firms can use different tasks in order to achieve the same aim. Companies often set themselves in mission statement; or they try to set goals by which the statement will be achieved; or a specific objective.
A firm aims to maximise profits, and that is what this essay will focus on. First, it will give a brief definition of firm and define its objectives. Second, it will examine the assumption of profit maximisation. Third it will confirm whether firms really maximise their profits. Then it will follow by mentioning other alternatives to profit maximisation. Finally in the conclusion, it will include the results of this essay.
It is understood by firm ‘ an organisation consisting of one or more individuals working as a decision-making unit to produce goods or services” (Atkinson, B. & R. Miller “Business Economics”). The firm”s objectives are to maximise profits.
The amount that the company receives for the sale of its output is called its total revenue. The amount that the firm pays to buy inputs is called its total cost. We, then, define profit as a firm”s total revenue minus its total cost.
Thus, if a firm gets £10,000 from selling its output and spends £90,000 producing this output, its profit is £10,000.
The above diagram shows how costs, revenue and profit interact with each other. Costs go up with output as well as revenue, but just till a certain point. Revenue falls due to the firm”s necessity to lower its costs in order to rise selling. In other words, in the cost curve firms will experience increasing returns, followed by decreased returns.
Revenue will rise, as price falls and quantity goes up. Profits will occur between the two points were the curves intersect. The slope of the two curves are the same and they are given by the marginal value (marginal revenue and marginal cost). Hence, to maximise profit, marginal revenue must equals marginal cost. In order to achieve this, firms must have all the details on the demanded product.
Profit maximisation plays an important role within a firm, as it makes innovation possible as well as the payment of higher wages and greater job offers. Moreover, profits create incentives as it is rewarding for entrepreneurs, whose time and skills contributed to the firm”s success. Increasing profits leads to a rise in output and with it consumers also get more satisfied. Thus, it can be said that it is also beneficial to society to raise profits. Profits provide a source of revenue, which reverts in favour of new factories and machinery. In addition, profits encourage innovation again society benefits from it.
However, there are still motives for companies to refuse to have high levels of profit. Companies will just be able to maximise profits if owners are in control of the firms. However, in big companies such as Coca-Cola or Shell where, probably, there are many shareholders, it is more difficult to maximise profits. As, in this case managers are more likely to run the business. This leads us to do so called ‘principal-agent problem”. Where owners” objectives may be different from the managers. Hence, due to the rise of the joint-stock company there has developed a split between ownership and control.
Ownership belongs now to shareholders, while managers exerce the power of controling. Still, there are motives to choose to maximise profits. Firstly, profit maximisation is still a sign of power, so in a competitive environment firms will opt to maximise profit to ensure its survival; Secondly, both the principal and agent, when confroting a situation of no option, they would prefer to maximise profits rather than lower them; Most important, due to profit maximisation it became possible for economists to study the output and the price of companies and, consequently, study the market.
In analysing the managerial approach, it can be noticed that managers will then aim to take precedents over the objectives of the owner. In this case the primary goal of a firm is to maximise its revenue. This will occur because managers” remuneration is more likely to be linked to revenue than to profitability. For example, bank”s tend to regard growing sales positive as well as financial markets, who likes to see growing sales revenue. Most important, sales revenue is still seen as an indication of success.
The same occurs to firms that have their main aim to maximise growth. Just like raising revenue, raising growth also leads to higher bonuses. Managers also benefit from it because their status gets better, as the firm has more prestige. Such theory, also suggests that managers try to maximise their own profit benefits. In other words, use firms to get their objectives.
Still, there is other theory that states that managers in fact do not maximise anything at all, but they attend to satisfactory levels, theory developed by H. Simon. Here, managers will set a minimum level of profit, keeping shareholders satisfied. This type of approach is probably used by small firms, which are not able to take the big risks that profit maximisation can lead to. Moreover, managers try to keep all members of the firm satisfied, so profit maximisation becames a hard task to achieve.
In general, conditions of uncertainty difficults the achievement of sales and profit maximisation. In practise management tries to obtain growth in output and assets from one year to the next and achieve satisfactory growth. On one hand, it is true to say that there is a separation of ownership and control, consequently, this stresses the importance of managers. On the other hand, it is difficult to describe how the different objectives of management and shareholders interact to produce the goals and objectives of the company.