What do firms aim for?
In economics we sometimes assume firms simply maximise their profits.
But do firms always maximise their profits or do they have other objectives?
In this post we will explore different business objectives and analysis / evaluation points for discussing these objectives.
Contents
Profit maximisation
Why might a firm maximise profits? Well there are several possible reasons.
Most obviously whoever receives those profits is better off. This could be the manager of the firm or its shareholders. Even when there are shareholders, a CEO or manager may benefit in terms of performance-related pay: the manager may be rewarded when the firm performs well.
Also higher profits may mean higher reinvestment by the firm into research and development (R&D). This could improve the product quality or reduce the cost of manufacturing. Both of these could benefit consumers in terms of consumers enjoying the higher quality or reduced costs being passed on to the consumers in the form of lower prices (provided the firm passes on such cost falls to the consumer!).
This of course depends on how the firm allocates the profits. Do the profits go to shareholders or to reinvestment?
Higher profits could be used for advertising instead, which may increase demand for the product and create brand loyalty.
However it is quite difficult to ‘maximise profits’ in the real world. This requires the firm to possess a lot of information for example on how costs and revenues vary with the quantity produced. The firm may also need to account for changing market conditions over time and so the quantity produced that maximises profits may also change over time.
Some firms are non-profits, set up for example as charities and are not aiming for profit but to improve social welfare or support a particular cause. There are other objectives that firms may pursue too, depending on the circumstances (see below).
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Revenues and costs under profit maximisation
Firms maximise profits where marginal revenue = marginal cost (MR=MC).
If MR>MC, then firms can increase the quantity being produced by one unit and increase profits.
But if MR<MC, then firms can decrease the quantity being produced by one unit and increase profits.
Sales maximisation
Why might a firm maximise its sales (here sales mean quantity / volume of units sold) instead of its profits?
Why can companies like Spotify make losses year after year and yet still attract large investments from new investors?
Increased sales allow a firm to increase its market share. This may allow the firm to gain monopoly power later on, which it can then use to increase prices and profits. The larger market share may help build customer loyalty.
Increased sales may allow a firm to reduce its long run average costs and hence achieve economies of scale.
When there is a divorce between ownership and control, even if a firm’s shareholders may want to maximise profits, the manager may choose to maximise something else. For example the firm’s manager could desire a higher status or better reputation, which could be achieved by the firm increasing its market share.
One could argue that lots of tech firms have engaged in sales maximisation. Not only Spotify, but also initially Amazon, Airbnb and even Uber. The Silicon Valley term for these business models is “blitzscaling”. Simply put, scale the business quickly at first then profits will come later on. For more about the idea of blitzscaling, I recommend checking out this YouTube video linked here.
There may be some industries where sales maximisation is similar to profit maximisation in terms of the resulting quantity. This may occur for example in industries with low variable or marginal costs for example internet businesses.
Sales (volume) maximisation occurs where average revenue equals average total cost (AR=ATC). Intuitively the firm tries to achieve as many sales as possible while having sufficient incentives to stay in the market and not shut down in the long run.
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Revenue maximisation
Revenue maximisation means maximising the total value of sales (as opposed to solely the quantity or volume of sales).
This occurs where marginal revenue equals zero (MR=0).
If marginal revenue exceeds zero, increasing the quantity of sales generates extra revenue by definition. But if marginal revenue is negative, the next unit sold would reduce revenue.
The reasons why firms may maximise revenue are somewhat similar to reasons why firms may maximise sales volume.
Lower prices and profits compared with profit maximisation may allow the firm to escape attention from regulators.
A firm could have an immediate need to generate quick cash. For example to avoid firm failure or to pay a bill.
Satisficing
Firms often have other stakeholders to satisfy. This could include workers, consumers or shareholder activists.
Also some firms may be content with a certain amount of profit rather than maximising profits.
Satisficing means achieving a certain level of profits while satisfying other stakeholders. This means that a monopoly for example may choose to set a lower price so it can both achieve some profits and satisfy consumers for example.
See more below on other particular stakeholders.
Graph
This graph shows the three business objectives mentioned above:
- Profit maximisation: MR=MC. Firm chooses quantity q and price p.
- Revenue maximisation: MR=0. Firm choses quantity q1 and price p1.
- Sales maximisation: AR=ATC. Firm chooses quantity q2 and price p2.
- You can also show satisficing with any price between p and p2. This shows the firm making some supernormal profit but not as much as it could.
Survival
Particularly when the economy is facing a downturn or if a particular industry is in structural decline, firms may turn towards the survival objective. This means the firm does everything possible to stay open.
Firms will primarily want to cover their minimum running costs. Also firms are less likely to invest in new machinery for example when trying to survive.
Hospitality firms have been hit both by the Covid-19 pandemic restrictions, rising energy costs and in some instances, consumers’ changing habits (numbers in pubs for example were falling pre-pandemic). Given hospitality markets can already be quite competitive, this makes the possibility of firm failure in these industries even more likely. So hospitality firms may be more likely to turn towards survival.
Other objectives
Environment
Companies may set their goal to manage the environment or reduce their level of pollution.
There may also be firms that are directly impacted by changing climate. For example remote island resorts, ski resorts or countries at large risk of flooding.
This could also be firms caring about their brand image and appearing responsible, as well as company bosses legitimately caring about climate change. More and more companies on the stock exchange are adopting “ESG” (environmental, social and governance) objectives which often include measures to reduce their level of pollution.
Improving worker pay and conditions
Improving worker pay may keep workers and potentially trade unions satisfied.
But there could be other reasons to improve pay. The “efficiency wage theory” is that raising pay increases worker productivity, for example because workers become more motivated to work. This could mean higher profits for firms. Higher wages could also help firms attract the top talent.
However brand image may be another motivation for firms to care about workers’ rights. The image of a firm exploiting workers in “sweatshops” with poor wages or working conditions may encourage consumers to avoid the products of that firm. Avoiding this by compensating workers well may simply increase the profits of the firm.
Satisfying consumers
Improving the quality of goods may encourage brand loyalty or “free” advertising through word of mouth or positive reviews. This could increase demand in the future or make demand more inelastic with respect to price.
We also discussed under improving working conditions the influence of consumers in forcing firms to improve workers’ conditions. A positive brand image may help to drive sales too.
Social welfare maximisation
Maximising social welfare means taking into account all the different stakeholders above.
Specifically it means maximising the sum of consumer and producer surplus or eliminating welfare loss. Where there are externalities such as pollution, social welfare maximisation should take these into account as well.
As a result, under social welfare maximisation, there will be no welfare loss.
Key evaluation points for business objectives:
- The objectives that firms can choose from are likely to depend on the market structure. In perfectly competitive markets, firms may have to maximise profits at least in the long run in order to remain in the market and not be undercut by competitors. However in a monopoly market the firm, facing less competitive pressure, may have a greater choice in terms of its objectives.
- Firms’ objectives may depend on the industry and its standard business model/cost structure. For example pharmaceutical companies take a long time over and invest heavily in research and development for new medicines for example. However as mentioned lots of tech companies may have lower marginal costs, for example Facebook faces very low costs to add extra users. So tech companies may seek to scale quickly to achieve market share (maximising sales).
- The power of various stakeholders. For example if there are strong trade unions in an industry then firms may have to cater more towards workers’ wages and working conditions.
- As mentioned above, we can claim that a lot of these other objectives are really about maximising profits. For example sales maximisation in the short run may allow the firm to maximise its long-run profits by increasing the firm’s market share.
- The objectives that firms choose may depend on whether the company has shareholders or whether the manager is also the owner. Where there is a “divorce of ownership from control”, the manager of a firm may set a different objective such as sales maximisation or improving their own reputation despite the shareholders wanting to maximise profits. However shareholders may be able to hold CEOs to account through annual general meetings or through well designed wage contracts.
- The pay structure of CEOs or managers. If bonuses for mangers are determined based on profits, the manager may be more likely to maximise profits. But if the bonuses are based on other factors for example market share, then managers may adjust their objectives accordingly.
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