The Firm’s
     Lesson Objectives
 Appreciate that firms, in addition
  to profit maximisation, have a
  range of objectives that they
  endeavour to satisfy

 In pairs explain the following terms:
• Profit-maximisation
• Normal profit
• Supernormal profit (Abnormal profit)
• Subnormal profit;

               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

• 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.
                       Big Picture
•   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
              Lesson Outcome

 Appreciate that firms may have a diverse
  range of objectives

                    Key Terms
• Public Limited Company   •   Stisficing;
  (PLC) ;                  •   Shareholders;
• Corporation ;            •   Carbon footprint;
• Director ;               •   Corporate citizenship;
• Perks;                   •   Market share;
• Dividends;               •   Market power;
• Share options;           •   Rational choice theory;
• Annual general Meeting   •   Capital market discipline;
  (AGM);                   •   Delisting;
• Activist shareholders;   •   Innovation.
• Hostile bid;

 A Firm’s

               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

• 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.

       Case Study – page 20
‘We Blew it’ – Nike admits to mistakes over
                 child labour

          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.

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

• 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.          17
 The Divorce of Ownership and
• 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
• Means the firm is producing satisfactorily but not maximum

• 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.
• 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.

      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.
Sales Maximisation Theory

 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
• 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.

 Sales Maximisation Theory
• This would be at the output of 400

• 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

• And this will reward managers
  rather than shareholders who
  would benefit from profit
 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.

    Inability to Profit Maximise
•   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.

•   The rational choice theory is can be unrealistic and that firms lack the information
    to make the choices that profit maximisation suggests.

•   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.

•   In practice, real-world firms are typically very complex, produce multiple goods,
    and detailed information on marginal cost is rarely available.

•   These factors make it almost impossible for a firm to make accurate assessment of
    whether it is profit maximising.

•   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.                                                           30
    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

• 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
  maximum profits.                                               31
          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
• 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.

                   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

• But do not adjust their output to maximise
  profits along the lines suggested by the
  traditional theory.
       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.

•   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
  require caution.                                                              34
           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

• 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.

               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.

                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

• 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.


The various objectives that a business might have

Examiner’s Tip

Activity – page 24

1.   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.
2.   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
3.   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
     costs are minimised.                                                       44
                                          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.
•   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.
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.
5. Comment on the statement that ‘expansion via the sale of Innocent is the best way for the company to 45
     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
      two or three other objectives.                                     47
                    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
     Weaknesses: diseconomies of scale and miscommunication
 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.
                         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
    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
    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

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