Profit Maximisation
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The production of goods and services in our economy today takes place within organisations, whether in the centrally planned economy or free market economy. Any firm within these societies all have the same tendencies to acquire a successful business. Attaining this succession through mission statements, goals and objectives is simultaneous through all businesses. Changes in these objectives can have forcible effects on the decisions that firms take day-to-day regarding pricing, output levels, the market and capital investment. Depending on the size of the corporation, objectives will evolve to meet changing economic conditions. The standard neo-classical assumption is that a business strives to maximize profits. Profit maximization is the process by which a firm determines the price and output level that returns the greatest profit, where marginal cost is equal to the marginal revenue. The theory of a firm tends to make this assumption because despite the growing importance for market survival and frequent calls for corporate social responsibility, creating a profit appears to be the most significant single objective of organisations in our market economy.
Economists have used the traditional profit maximization theory as a matter of debate whether the firm survives and develops in order to provide a profit or makes a profit by which it can survive and develop. Any firm has
to take into account how the market determines the price for goods or services which they supply. Applying the theory of supply and demand helps organisations to reach decisions. Using a demand curve defines the price, total revenue and marginal revenue associated with each level of output, where price changes act as the mechanism whereby supply and demand are balanced. In 2000, Clark dictated that, “a supplier should stop when the revenue made on the last item produced is no more than it cost to provide.” (Pg 52) Past this point, profits deteriorate relentlessly, as the law of diminishing returns prescribes that the costs involved in producing an extra unit of output go up, whilst the demand curve dictates that the revenue from each extra unit sold goes down. In turn, the firm should respond to the supply and demand signals (e.g. changes in costs) by adjusting its pricing policy, output or both. They should also be able to indentify values of revenue and cost, conjoined with each level of output and in so doing, identify a profit maximizing position. The concept of price elasticity allows the firm to analyze supply and demand with greater precision and is a measure of how much buyers and sellers respond to changes in the market. The principle assumes that a business needs to make at least normal profits in the long run to justify remaining in the market; however this is not a strict requirement in the short term. In the short run the firm should
continue to produce as long as revenue costs covers total variable costs.
Within our economy owners and managers represent two different groups of decision makers. It is implied that shareholders possess the desire of profit maximization to be the preferable target of any business with which they hold equity, thus providing them with more wealth. However in practice this is not always the case as the debate over the divorce of ownership and control comes into play.
In theory; the shareholders being the owners of the firm will control its activities. However, in practice this can be difficult amongst larger corporations as control often lies in the hands of the directors. It can be tough for any firm to exact change for the thousands of shareholders, each with a small stake. Thus in many firms there is what is called the division of ownership and control. The separation of ownership and control raises worries that the management team may pursue objectives attractive to them but which are not necessarily beneficial to the shareholders. This conflict is what is known as the principal agent theory. As defined by Hornby, Gammie and Wall (Pg 164, 2001), the P-A theory, “considers the relationship between the owners of the firm and the managers and also the relationship between the managers and those they manage.” The relationship occurs when one person, the principle, employs an agent to perform tasks on their behalf. It is assumed that
each wants to maximize his or her profit but that each is subject to constraints. In this case, shareholders are the principals who employ the managers to maximize profits on their behalf.
The concept of principal-agent can explore in greater detail the barriers imposed for each party involved. Recited from Worthington, Britton and Rees (Pg 41, 2001), “firstly there is an imbalance in power between the principal and the agent; secondly there is likely to be a divergence of interests between the principal and the agent and the possibility of opportunism exists.” One problem in assuming that businesses set price and output to maximize profits is the decision-taking; where the divorce between ownership and control, can be difficult to monitor. The shareholders may not always be aware that managers making the key day-to-day decisions are operating to maximize shareholder value. Hornby et al. indicates that different problems also associated with the P A theory include moral hazards and adverse selections. Both factors coincide with information deficiencies for both the shareholders and the managers. Another proposition by Hornby et al. signifies that one way of prevailing such disputes between the principals and the agents would be, “to try and devise contracts which bring about a coincidence of aims” (Pg 164, 2001). Incentives such as bonus schemes or shares and share options could be used. This gives the managers a powerful incentive
to act in the interests of the owners by maximizing shareholder value. A predicament affiliated with such rewards may lead to accounting fraudulency. In practice, Enron, the American based energy company abdicated responsibility to their senior managers who then in turn were able to abuse their position and the system to their own advantage. Deakin and Konzelmann (2003) denote that Enrons collapse “was the consequence of a corporate governance system focused at all costs on the goal of enhancing shareholder value.” This makes an impact on the traditional neo-classical presumption of profit maximization not always being the core objective of the firm, as market survival amongst other things, have a significant role. Also in the case of Enron, presenting employees with share options, the managers dishonestly tampered with the accounts to achieve maximum share prices in order to sell them in the short run to attain more wealth. In the long term this lead to Enron facing their