Student Number: 0117602

01/11/2001

Is profit maximisation a satisfactory assumption when modelling the behaviour of firms? Why?
Economists have traditionally assumed that firms want to maximize profits. But do firms necessary want to maximize profit? When we attempt to establish what the objectives of firms might be, the distinction between managers and owners is crucial. This essay looks at the role of firms in the economy. Section one explains how firms are concerned to use inputs to make outputs and how managers analyse their choices in order to make profits. Section two talks about the role of the firm and its organisational structure whereas section three deals with profit maximisation theory. On section four and five is a contrast between long-run and short-run profit maximisation. Section six deals with relation between profitability and the growth of the business and the last section gives some conclusions about different alternative theories when we modelling the behaviour of firms. Firms will normally wants to make as much profit as possible. By thinking to maximise profit, the firm could fulfil the human wants, which are defined as scarcity. Firms are concerned to use inputs to make outputs, which it means to spend money in order to make money because inputs cost money and outputs make money then the difference between them gave the profit. In order to stay in business firms will do what they can to avoid a decline in profit. But to achieve these objectives managers need to make choices. They need to decide out type of output to produce and at what price? What technology to use and what number and type of workers to employ? To be successful and at least not to decline the profit, firms need to analysis these factors into political, economic, social and technological (PEST), which will help to establish a strategy. As it is stated on Economics for Business (Sloman, J and Sutcliffe, M, 2001) most production decision are not made by individuals who will consume the product but by the firms. So the firm is an economic organization that coordinates the process of production and distribution. Firms were seen as simple organization that produce output by employing inputs, and no attention was paid how they were organized and how they would influence their behaviour. The legal structure of firms have subsequent performance within the market place and there are several types of firms. Organizational structure of the firm leads to the success of a business organization. Firms are organized internally in different ways, which it is depends on their size. Large firms organisational structure is more complex than small firms. As firms grow they tend to move from centrally managed into separate departments, such that responsibility is separated from the formulation of the business strategic plan. Economists have traditionally assumed that firms want to maximise profits. As quoted on Economics for Business (Prentice Hall, 2001) this theory have been criticized mostly for two reasons for being unrealistic. First one is that firms may want to maximise profits but they are unable to do so or firms may have aims other then profit maximisation. Shareholders and managers think different about profit maximisation. Owners of the firm may want to maximise profits. By referring on (Economics for Business, 2001) the twin process of managerial expansion and widening share ownership led Berle and Mains (The Modern Corporation and Private Property, Macmillan, 1933) to argue that the ownership of joint-stock-company no longer meant

Student Number: 0117602

01/11/2001

control over its assets. So, the business has grown nowadays and modern companies are legally separate from their owners, it will be the person or the group in charge of the business (in this case managers) to make decisions. Managers may have different ideas about profit maximisation. They may want to maximize their own interests for example to maximize their own utilities, higher salary, greater security, greater sales, better working conditions, greater prestige or popularity with their subordinates. By having other aims rather than profit maximization, conflicts could be developed between managers and shareholders. To avoid this conflict, managers need to ensure that sufficient profits are made. The sufficient profit is the target level of profit that managers strive hard to achieve in order to keep owners happy. By referring to the Financial Times newspaper (October 18, 2001) about profit warning focused on Financial Times Group, the sufficient profit for them was last years profit. After a drop in advertising revenue the owner of Financial Times told investors that profit will be below expectation. This is a case that they want to maximize their profits in the long run. Some firms may chose to maximise profits over a long time period. If the firm becomes larger with a larger share of the market, the economic power may help the firm to make more profits in the long run. But in the long run profit maximization, the prices and outputs can not be calculated precisely. Managers salaries, power and prestige may depend on sales revenue. The success of managers may be judged according to the level of the firms sales. So, managers may aim to maximize the firms short-run total revenue. This is an alternative theory, which it is called sales revenue maximization and it is easy to identify the price and output that meet this aim. Also, profitability is related to the growth of the business. The more profit a firm can make, the more access to the cheap finance a firm can have, which it leads to more investment and growth of business. Firms may want to grow but it might not be possible because of several factors that can restrict the ability of business to expand. Growth above a certain rate may be at the expense of profits. Some firms may want to maximize profit rather than business growth. But in order to remain in the market place, they may be forced to grow. When modelling the behaviour of the firm, there are different alternative theories. Some firms may think to grow their business whereas others may think to maximize their profits. Owners and managers may have different thoughts about profit maximisation and this theory has been criticized for two major reasons. Also, if sales revenue maximization has a dominant sales department, it may be a more dominant aim in the firm than profit maximization. Other alternative theories of the firm assume that, large firms aim for a target level of profit rather than absolute maximum level, so they are called profit satisfiers. Bibliography Sloman, J and Stcliffe, M (Printice Hall, 2001) Economics for Business

Student Number: 0117602

01/11/2001

Newspaper (08/10/2001) Financial Times Adolf A, Berle and Gardiner C, Means (1933) The Modern Corporation and Private Property as quoted on Economics for Business (Printice Hall, 2001)