Every firm has an objective according to which it behaves in the market structure. Let’s study the objectives of firms and their motives.
What is a firm?
In simple terms, firms are companies. They are legally recognised bodies that provide goods and/or services to their consumers, government bodies, and other businesses.
A firm is an organization that combines and organizes resources for the purpose of producing goods and services for sale at profits.¹
Firms can be divided on the basis of their legality, nature of work, number of owners, size, and need for its resources. Firms can be broadly classified into three main categories. These categories are then divided into subcategories:
Private sector
Proprietary firms
Partnerships
Companies
Cooperatives
Public sector
Companies
Corporations
Departments
Joint sector
Figure 1 should help you remember.
All the firms may have varied objectives depending on their production capacity, nature of business, competition, and other factors.
The main objective of firms: profit maximisation
The first and most important objective of any firm is to maximise its profit. The basic profit calculation is the total revenue minus the total cost. In economics, profit refers to the returns over and above the opportunity cost. It is also sometimes referred to as pure profits.
There are a few reasons why profit maximisation is the main objective of most firms:
Re-investment: firms want to maximise their profit to re-invest the amount for further buying new technology, research, and development, etc.
Dividends: firms may wish to have better profits to allow for greater dividends for the shareholders.
Maximum profit is also one form of reward for entrepreneurship for the owners’ risk-taking.
The profit-maximising rule (MC = MR)
Profit maximisation occurs at a production quantity where marginal cost is equal to marginal revenue. This is easier to understand with the help of a diagram.
The Profit maximising rule states that MC = MR as shown in Figure 1 at point M. Let’s see why the profit is maximised at this point.
Fig. 2 - Profit maximisation
If we move to the right of the profit-maximising point, M, the marginal cost curve is above the marginal revenue curve. This means that there is only loss for any units above the profit-maximising quantity, Qm. This results in the reduction of profits.
On the other hand, if we move to the left of the profit-maximising point, M, the marginal revenue curve is above the marginal cost curve. This means that any additional unit produced will increase profits until the profit-maximising quantity, Qm is reached. This happens at the point where the marginal revenue curve meets the marginal cost curve. Hence, the firm will choose to produce at this profit-maximising point where MC = MR. The price that the firm will set is read off the AR curve at the profit-maximising quantity, Qm (point P in Figure 2.)
Other possible objectives of firms
Most firms have a basic objective of profit maximisation. However, for many reasons, some firms may also try to fulfill other objectives:
If a firm has a too large level of profit, this may result in the regulators' investigating it. They may scrutinise the firm's processes and ask to reduce prices to meet customers’ demands.
Sometimes, firms may not have a profit-maximisation objective as they are not able to ascertain their actual marginal cost and marginal revenue.
Other objectives may be more crucial for the firm over profit maximisation.
Growth maximisation/sales maximisation
The firms may pursue the objective of sales maximisation which can also be referred to as growth maximisation. A firm achieves sales maximisation when the average cost (AC) is equal to the average revenue (AR) which is also a point at which a firm breaks even (makes zero profit.) This is represented by point S in Figure 3 below:
Fig. 3 - Growth Maximisation
Here are some reasons why firms would have sales maximisation as their objective:
1. Economies of scale
When the firm increases the production levels to reduce its cost of production, it helps to create economies of scale. As the output increases, firms aim for higher sales.
2. Market flooding
This is the marketing tactic a firm uses to hammer the consumer’s memory with the firm’s product by showing it everywhere possible. This kind of strategy helps the firms to gain more market share and at the same time loyal customers.
3. Limit pricing
Here the firm prices its product at the break-even point. The price allows it to make only normal profit, which takes away the incentive for new firms to enter the market.
Revenue maximisation
Revenue maximisation occurs when marginal revenue is equal to zero (MR = 0.) This is also a point where the MR curve crosses the quantity axis. The price, as always, is read off the AR curve. This is represented by point R in Figure 4 below:
Fig. 4 - Revenue maximisation
Revenue maximisation (at point R) can help the firms increase their produced quantities whilst lowering their prices compared to the prices in profit (at point P) or sales maximisation (at point S.)
Again, profit maximisation occurs at the point M where MC = MR. We read the price from the average revenue (AR) curve at point P, which gives us the price, Pm, and quantity, Qm, for profit maximisation.
Similarly, revenue maximisation occurs when marginal revenue equals 0. We read the price from the average revenue (AR) curve at point R, which gives us with the price, P2, and quantity, Q2, for revenue maximisation.
Clearly, at the point of revenue maximisation, the prices are lower and the quantities are higher than those determined for profit maximisation. Hence, firms may be willing to go for revenue maximisation over profit maximisation.
With the objective of revenue maximisation, the firm may cut down the competition by charging lower prices and taking the market share away from its competitors.
The satisficing principle
The satisficing principle refers to sacrificing profits to satisfy as many key stakeholders as possible. The word satisficing comes from ‘satisfy’ and ‘sacrificing.’ A satisficing principle often happens when stakeholders have conflicting interests. Stakeholders can be anyone associated with the firm including consumers, employees, shareholders, trade unions, or the government.
Each stakeholder may have a different motive for running the business, resulting in not having profit maximisation as their main objective.
Workers may be unhappy if they are underpaid due to cost-cutting and would want firms to pay them better sacrificing the profit margin. Similarly, the government may also want a firm to reduce its profit margin and pass the benefits to the consumer who might be overcharged.
Survival
Survival is another objective some firms might pursue in the short run. Some firms decide to survive to capture market share and gain consumers’ loyalty over profits or sales. In fact, in some cases, the firm may also experience losses. However, if they can survive in the short run, they would be able to sustain and reverse the losses in the long run.
Corporate social responsibility
Corporate social responsibility has been gaining importance recently. More firms are aiming to be socially responsible to gain more customers’ trust and to be environmentally friendly. This allows them to be within the rules and regulations of the government.
Increasing market share
The firm may want to increase its market share, which will help it expand and result in a better position in the market over its competitors. Also, some firm managers like to manage big companies and create more opportunities for employees.
Effects of divorce of ownership from control on firms’ objectives
In many companies, the owners are different from those who manage the business. The owners don’t control the company. This isn’t usually the case in small companies. In larger companies, the owners are the shareholders while those who manage the company are the directors. The owners’ objectives may be different from the directors’ objectives.
This is known as a divorce of ownership from control or the principal-agent problem. The principals are the owners and the agents acting on behalf of the owners are the managers.
The managers who control the company know the day in and day out of the business and may have objectives of revenue maximisation, such as giving their employees better perks, good health benefits, bonuses, etc.
On the other hand, the owners or shareholders may have an objective of profit maximisation so they can get better returns and the value of their shares increases.
Objectives of Firms - Key takeaways
- Firms are legally recognised bodies that work to provide goods and/or services to their consumers, government bodies, and other businesses.
- In economics, profit refers to the returns over and above the opportunity cost. It is also referred to as the pure profits.
- The main objective of most firms is profit maximisation. They can use it for re-investments, giving better dividends, rewards for entrepreneurship, etc.
- Profit maximisation occurs when marginal cost is equal to the marginal revenue.
- The objective of sales maximisation is achieved when the average cost is equal to the average revenue which is also breakeven.
- Revenue maximisation occurs when marginal revenue is equal to zero.
- The satisficing principle refers to sacrificing profits to satisfy as many key stakeholders as possible.
- The divorce of ownership from control is also called the Principal-Agent problem.
Sources
1. Dominick Salvatore, Managerial Economics in a Global Economy, 2010.
