We now turn to the aims and objectives of businesses. This is a complex and interesting area of the subject since changes in business objectives can have quite powerful effects on the decisions that businesses take day-to-day regarding pricing, output levels and spending on advertising, market and capital investment. Often the objectives and targets of a corporation or small enterprise will evolve to meet changing economic conditions.

Profit maximisation

The traditional theory of the firm tends to make a standard assumption that businesses possess the information, market power and motivation to set a price and output that maximises profits in the short or long run. This assumption is now criticised by economists who have studied the organisation and objectives of modern-day corporations and in particular the existence of a ‘divorce of ownership and control’ that is common to most large scale corporations.

Why might a business depart from profit maximisation?

There are numerous possible explanations. Some relation to the lack of accurate and detailed information required to undertake optimal maximising behaviour. Others concentrate on the alternative objectives of modern businesses. We start first with the effects of imperfect information.

Imperfect information about Demand and Cost Conditions

One reason why firms might depart from profit maximisation is that it is difficult for them to identify their profit maximising output, as they cannot accurately calculate marginal revenue and marginal costs. Often the day-to-day pricing decisions of businesses are taken on the basis of “estimated demand conditions” rather than a systematic calculation of a demand curve. Most modern businesses are multi-product firms operating in a range of separate markets. The amount of information that they have to handle can be vast. And they must keep track of the changing preferences of consumers and ever-evolving market conditions. The idea that there is a neat and single profit maximising price is really redundant.

Behavioural Theories of the Firm

Behavioural economists believe that modern corporations are complex organizations made up of various groups or stakeholders. Stakeholders are defined as any identifiable groups who have a vested interest in the activity of a business. Examples of relevant stakeholders might include:

• Employees within a business
• Managers employed by the firm
• Shareholders – people who have an equity stake in a business
• Customers in the market
• The local community
• The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at different points in time. The dominant group at any moment in time can give greater emphasis to their own objectives – for example price and output decisions may be taken at local level by managers – with shareholders taking only a distant and imperfectly informed view of the company’s performance and strategy.

If firms are likely to move away from pure profit maximising behaviour, what are the alternatives? The reality is that there are numerous different strategies that can be employed. Although a business might have profitability as an important medium-term aim, it might depart from this in the short term.

Here are some alternatives to pure profit maximisation strategies:

1. Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit.
2. Sales Revenue Maximisation

The objective of maximising sales revenue rather than profits was initially developed by the work of William Baumol (1959). His research focused on the behaviour of manager-controlled businesses – price and output decisions taken by managers are divorced from the shareholders (the owners of the business). Baumol argued that annual salaries and other perks might be more closely correlated with total sales revenue rather than profits. Companies geared towards maximising revenue are likely to make frequent and extensive use of price discrimination (or yield management) as a means of extracting extra revenue from consumers.

3. Managerial Satisfaction model

An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or utility). This can be enhanced by success in raising sales revenue.

4. Constrained Sales Revenue Maximisation

Shareholders of a business may introduce a constraint on the decisions of managers – known as constrained sales revenue maximisation. For example hey may introduce a minimum profit constraint designed to underpin the valuation of their shares and maintain a dividend.

The diagram below shows how price and output differs if the firm changes its objective from profit to revenue maximisation. Assuming that the firm’s costs remain the same, a firm will price lower and produce a higher output when sales revenue maximisation is the main objective.

The profit maximising price is P2 at output Q2 whilst the revenue maximising price is P1 at output Q1. A change in the objectives of the business has an effect on economic welfare and in particular the balance between consumer and producer surplus. Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower.

Price and Output under Constrained Profit Maximisation

Shareholders might attempt to “constrain” the price and output decisions of managers by introducing a minimum profit constraint.

Consider the following diagram on the next page:

• The normal profit maximising output is at Q2 (where the vertical distance between the total revenue and total cost curve is at its greatest)
• Revenue is maximised at output Q1 where the total revenue curve reaches a maximum (i.e. marginal revenue is zero)
• If shareholders insist on the business achieving a minimum profit as shown, then the managers of a business have the discretion to vary price and output anywhere between Q2 and Q4
• At any output beyond Q3 (where total revenue and total cost intersect) losses are made

The short run supply decision - the shut-down price

The theory of the firm assumes that a business needs to make at least normal profit in the long run to justify remaining in an industry but this is not a strict requirement in the short term. In the short run the firm will continue to produce as long as total revenue covers total variable costs or put another way, so long as price per unit > or equal to average variable cost (AR = AVC).

The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs are sunk costs (i.e. they cannot be covered if the firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

 

Consider the cost and revenue curves facing a business in the short run in the diagram above.

• Average revenue (AR) and marginal revenue curves (MR) lies below average cost across the full range of output, so whatever output produced, the business faces making a loss
• At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is less than AVC. The loss per unit of producing is vertical distance AC
• If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.

Deriving the Competitive Firm’s Supply Curve in the Short Run

In the short run, the supply curve is the marginal cost curve above average variable cost.

In the long run, a firm must make a normal profit. When price = average total cost, this is the break-even point. It will therefore shut down at any price below this in the long run.  As a result the long run supply curve will be the marginal cost curve above average total cost.

A supply curve can only be derived from the marginal cost curve for firms operating in perfectly competitive markets. The concept of a ‘supply curve’ is inappropriate when dealing with monopoly situations because a monopoly is a price-maker, not a “passive” price-taker, and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost.