The objectives of firms

Study Notes: The Objectives of Firms (9640 Economics)

Hi there! Welcome to one of the most fundamental and practical chapters in business economics: understanding what firms are actually trying to achieve. Why is this important? Because a firm's objective (what they aim for) dictates its behaviour (how they set prices, how much they produce, and how they compete). Get ready to step into the boardroom!

I. Profit Maximisation: The Traditional Assumption

In traditional economic theory, we start with a very clear, simple assumption: the primary objective of virtually all private sector firms is profit maximisation.

What is Profit?

Profit is simply the difference between the money a firm brings in (Total Revenue) and the money it spends (Total Cost).

\[\text{Profit} = \text{Total Revenue (TR)} - \text{Total Cost (TC)}\]

Key Definitions of Profit

• Normal Profit: This is the minimum amount of profit a firm must make to keep its resources (factors of production) employed in their current use in the long run. It covers all opportunity costs. If a firm only makes normal profit, it means TR = TC.
• Abnormal Profit (or Supernormal Profit): This is any profit made above the normal profit level. It means the firm is earning more than is required to cover its explicit and implicit (opportunity) costs. If a firm makes abnormal profit, it means TR > TC.

💡 Memory Aid: The Two Types of Production Decisions

The assumption of profit maximisation guides a firm's decision on whether to continue operating in the short run and the long run:

1. Short Run Production Decision:

• A profit-maximising firm will continue to produce in the short run if it can cover its variable costs (e.g., raw materials, wages).
• If Total Revenue (TR) is greater than or equal to Total Variable Costs (TVC), the firm produces. Why? Even if it makes a loss, this loss is smaller than the fixed costs (FC) it would have to pay if it shut down completely.

2. Long Run Production Decision:

• A profit-maximising firm will only produce in the long run if it can make at least normal profit.
• If the firm cannot cover all its costs (both fixed and variable, meaning TR < TC), it will exit the industry in the long run.

Key Takeaway: Traditional theory places profit maximisation at the heart of firm behaviour, using specific criteria (covering costs) for production in the short run and long run.

II. A Variety of Objectives: Beyond Pure Profit

Economists recognise that real-world firms, especially large ones, pursue a variety of other objectives beyond just maximising short-term profit. These objectives are important because they influence the firm's overall strategy.

1. Survival

For new firms (start-ups) or firms facing intense competition or a recession, survival may temporarily override profit maximisation. The immediate goal is simply to stay in business, even if that means making a loss or only normal profit for a while.

Example: A small, independent bookstore may offer unique events or services at low margins just to build a loyal customer base and survive against larger online competitors.

2. Growth (Maximising size or output)

Firms often aim for growth, measured by size (assets, capital) or sales volume, for several reasons:

• Achieving Economies of Scale: Becoming bigger reduces average costs.
• Security: Larger firms are more stable and less likely to be taken over.
• Market Dominance: Growth is necessary to increase market power.

3. Increasing Market Share

Market share is the proportion of total sales in a market that a firm accounts for. Increasing market share is often a long-term strategy that requires aggressive pricing or heavy advertising, which may reduce current profits.

Did you know? Companies like Spotify or Uber often prioritize increasing market share by charging low prices to attract users, knowing that higher profits will come later once they dominate the industry.

4. Maximising Sales Revenue

Some firms, especially those with high fixed costs, might aim to maximise their total sales revenue (TR) rather than their total profit.

• This often means producing a higher quantity and accepting a lower price than the profit-maximising point.
• Maximising revenue can impress banks and shareholders, making it easier to raise funds for future investment and growth.

5. Quality and Customer Satisfaction

Especially in service industries or luxury markets, a firm's main focus might be high quality, good reputation, or superior customer service. While this costs money in the short run, it builds brand loyalty and market share, leading to higher long-run profits.

Example: A high-end restaurant focuses on expensive ingredients and excellent service (costly), prioritizing reputation over immediate profit maximisation.

Key Takeaway: Real-world firms balance short-term profit with longer-term goals like security, growth, and market influence.

III. Challenges to the Profit Maximisation Objective

Why do firms choose these alternative objectives? Often, it's due to information problems or the structure of the business itself.

1. Divorce of Ownership from Control (Principal-Agent Problem)

This is a crucial concept, especially for large, publicly listed companies:

• Owners (Shareholders): Own the company and are concerned with maximising their financial return, meaning maximum profit. They are the Principals.
• Managers (Directors): Run the company day-to-day. They are the Agents.

In large firms, managers often own very little of the company. Their objectives might be different from the owners' objectives. Managers might prioritise:

• Higher salaries and perks (e.g., luxury offices, company cars).
• Expanding the size of the firm (growth), as this often correlates with higher management prestige and power, even if it doesn't maximise profit.

Since the owners cannot perfectly monitor every decision made by the managers, the managers may pursue their own interests, leading to the firm operating away from the maximum profit point.

2. The Satisficing Principle

The divorce of ownership from control leads directly to the concept of satisficing.

• Definition: Satisficing means aiming for a satisfactory or "good enough" level of profit, rather than striving for the absolute maximum profit possible.
• Why it happens: Managers want to achieve enough profit to keep the shareholders happy (to avoid being fired or taken over) but then use the remaining operational freedom to pursue their own goals (like growth or perks).

Analogy: Think of studying for an exam. Maximisation means getting 100%. Satisficing means getting a B grade, which is 'good enough' to pass the course, and then spending the extra time doing something you prefer.

3. Government Ownership/Control

If a firm is government-owned or heavily regulated (like a national railway or postal service), its objectives shift away from profit entirely. Government-controlled firms often aim to:

• Maximise social welfare (e.g., providing universal service, even to remote, unprofitable areas).
• Provide essential services at an affordable price, regardless of cost.
• Maintain high employment levels.

These social objectives often conflict directly with profit maximisation.

Key Takeaway: The structure of the firm and who controls it determines whether profit maximisation is realistic or whether alternative objectives like satisficing take priority.