CHAPTER 2

OBJECTIVES OF BUSINESS FIRMS

INTRODUCTION

The sole and only objective in the traditional theory of the firm has been profit maximization.this objective
occupied the centre stage of economictheories till 1939 when R.L. Hall and C.J. Hitch with the help of their
empirical studies,challenged both the profit maximization and the marginalistic behavioural rules.

THE FIRM AND ITS OBJECTIVES

A firm is a technical unit in which commodities are produed for sale to other economic units like
individuals,households,firms and government bodies.

MAXIMISATION OF PROFIT

The traditional economic theory assumed profit maximization as the sole objective of the firm.Under perfect
competition, the price of a commodity is determined by the forces of demand and supplay.Since the firm is one
among the many firms.,its action has no perceptibleinfluence on price and supply.The firm is a price taker and a
quantity adjuster.That is ,by accepting the market price the firm can sell any amount of product it likes.The
difference between the total revenue and total cost is the economic measure of profit.It is the residue that is left
after payment to all factors of production have been made.

SALES MAXIMISATION

Baumol’s theory of sales maximisation is an alternative theory of a firm’s behaviour.The hypothesis rests on the
separation of ownership and management found in firms.Being a consultant to a number of firms in America ,he
points out that most managers seek to maximize their sales revenue rather than profits.He argue that the
managers in oligopolistic markets must earn a minimum level of profits to keep the share holders satisfied and
only after that ,they may pursue other things.In simple terms Baumol’s sales maximization hypothesis suggests
that the maximization of sales revenue subject to a profit constraint may be a more likely goal of large businees
firms than the mere assumption of profit maximization.

SECURITY OF PROFIT
According to prof:Rothchild the main aim of a firm is not profit maximization ,but a steady flow of profit for a
long time.In other words, it is interested in getting secure profits for a long period of time rather than profit
maximization.

Rothchild argues that the objectives of profit maximisation is valid only under conditions of perfect competition
or monopolistic competition,where there are a large number of firms.This is true under true monopoly also.In
these forms of market, problem of security does not arise.For the pure monopolist ,security against competition
is ensured by virtue of his monopoly power.And for a small competitor the security question is a very urgent
one;the market conditions have such an overwhelming force that he alone cannot do anything to safeguard his
position.Maximisation of profits is therefore a legitimate generalization about their behaviou of an entrepreneur
in such cases.
But Rothchild points out that in the field of duopoly and oligopoly this assumption is no longer valid.Under
oligopoly,a firm is not motivated by profit maximization.It is engaged in a constant struggle to achieve and
maintain a secure poition in the market,like a military strategit.

MAXIMISATION OF SATISFACTION
Prof;Scitovsky favours satisfaction maximization in the place of profit maximization.According of Scitovsky
the satisfaction of an entrepreneur does not depend only upon the material goods in the form of comforts and
necessaries obtained by him out of the profits due to his entrepreneurial activity.It includes the leisure or what
Hicks calls aquiet life’ also as an essential ingredient of individual welfare.

Scitovskyargues that an entrepreneur would profits only.if his choice between more income and more leisure is
independent of his income.If an entrepreneur works more,less time will be available to him for leisure therefore
the satisfaction and keep his effortsand output below the level of obtaining maximum profits.

UTILITY MAXIMISATION

Oliver E.Williamson has developed the managerial utility hypothesis,managers seek to maximize their own
utility function,subject to a minimum leval of profit.A minimum leval of profit is necessary to satisfy the
shareholders or to keep the managers position unchanged. The utility of the self seeking managers depends
upon three factors.1)no.of persons working as subordinates,known as staff ,2)perquisites enjoyed by managers
and,3)discretionary powers to sanction investment project.Thus the hypothesis states that a long as a firm
earnsprofit which meet the minimum requirements of the owners,managers seek to maximize their own utility
functions.

.
SATISFICING
Prof Herbert Simon has developed a theory which emphasizes that the objective of a firm is not profit
maximization but satisficing.According to Simon,the firms may prefer the quite life and may be satisfied in
achieving a certain minimum level of profits,a certain share of the market or certain leval of sales.

GROWTH MAXIMISATION
According to Marris the main goal of a firm is the balanced rate of growth of the firm.It means the maximization
of the rate of growth of demand for the products of the firm and the rate of growth of its capital supply.By
maximizing these variables,managers maximize their own utility functions and also the owners’ utility functions.

OTHER POSSIBLE OBJECTIVES

Papandreou says that organizational objectives grow out of an interaction among the various participants in the
organization.this interaction produses a general preference function.

Cooper argues that business attempt to maintain liquidity sufficient”s to assure the firm’s financial position,

3. DECISION MAKING

Decision-making is the process of selecting a particular course of action from among the various alternatives
available.

Most of the economic theories are based on perfect knowledge which implies certainty. In real life, a firm
may experience uncertainty regarding market trends, reaction of competitors, and of government policies. In
fact, most decisions have to be made under varying degrees of risk and uncertainty. Risk refers to a situation
where there is more than one possible outcome to a decision and the probability of each specific outcome is
known or can be estimated. Uncertainty is the case where there is more than one possible outcome to a decision
and the probability of each specific outcome occurring is not known. The ability of an efficient manager lies in
taking a correct decision when the information and time available are limited.

The following chart depicts the process of decision-making.

Alternative Selection of a Execution of Result of Action

courses of Action particular Action Action

Full realization of
objective
Action A Decision A chosen
making plan of
Action B Partial realization
Action
of objective
Action C

Non-realization of
objective

Now the question is how to take a decision. Since the knowledge of the future uncertain the managements have
to make decisions daily and also formulate plans for the future. There are various ways in which decisions can
be made, ranging from ‘off the cuff’ guess work to fully informed conclusions combined with good judgement.
Mainly there are five fundamental concepts that are used in decision making viz.,

i. Incremental concept

ii. The concept of time perspective

iii. The discounting principle

iv. The concept of opportunity cost and

v. The principle of equi-marginalism

 4. FUNDEMENTAL CONCEPTS USED IN MANAGERIAL

ECONOMICS

Five fundamental concepts that are basic in study of managerial economics are as follows:

1. The incremental concept

2. The concept of Time perspective

3. The Discounting principle

4. The concept of opportunity cost

5. The principle of equi-marginalism

4.1. The Incremental Concept

Incremental concept is closely related to the marginal revenues and marginal cost of economic theory.
Incremental reasoning involves estimates of the impact of decision alternatives on costs and revenues, stressing
the changes in total costs and total revenue that result from changes in price, products, procedures, investments,
or whatever may be at stake in the investment decision.

The two basic concepts involved in this analysis are incremental cost and incremental revenue.
Incremental cost is the change in total cost consequent upon a decision. Likewise incremental revenue is the
change in total revenue due to decision.

The decision criterion according to this concept is “Accept a particular decision if it increases the revenue
more than it increases the cost, as assessed from the managerial point of view”.

Other variants of this principle are: if:

i. It decreases some costs to a greater extent than it increases others

ii. It increases some revenues more than it decreases others: and

iii. It reduces costs more than revenues

4.2. Implications of Incremental Reasoning

Incremental reasoning is significant, for some business hold an erroneous view that to make an overall profit
they must make a profit on every job. The result is that they often refuse orders that do not cover

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Full cost (labor, materials and overhead) plus some provision for profit. But incremental reasoning shows that
this rule may be inconsistent with profit maximization in the short run. It can be seen from the following
illustration that a refusal to accept business below full cost means a rejection of a possibility of adding more to
revenue than to cost.

Illustration

Suppose a new order is estimated to bring in Rs. 20,000 by way of additional revenue. The cost as estimated by
the company’s accountant is as follows:

Labor………………………………………………………….Rs. 6,000

Material………………………………………………………...Rs. 8,000

Overhead (allocated at 120% of labor cost) ………………….Rs. 7,200

Selling and administrative expenses

(allocated at 20% of labor and material costs)………………..Rs. 2,800

-------------------------

Full Cost Rs. 24,000

--------------------------

The order appears to be unprofitable, because, if it is accepted it will result in a loss of Rs. 4,000. But suppose
that there exists an idle capacity with this order could met. Further suppose the order adds only Rs. 2000 to
overheads (the incremental overhead is limited to the added use of heat, power and light, the added wear and tear
to the machinery, the added costs of supervision etc). The order does not require any selling and administrative
costs, as the only requirement is the acceptance of the order. In addition, only a part of the labor cost is
incremental because some of the idle workers already on the pay roll will be employed without any additional
pay

The incremental cost of accepting the above order may be as follows:

Overheads……………………………………………………….Rs. 2,000

Materials…………………………………………………………Rs. 8,000

Labor………………………………………………………… Rs. 4,000

----------------------------------

Total incremental cost Rs. 14,000

Therefore, contrary to the accountant’s estimate of a loss of Rs. 4,000 the order will result in an addition of Rs.
6,000 as profit. The application of the incremental principle maximizes short run profit, but not long-run profit.

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4.3. The Concept of Time Perspective

Economists make a distinction between short-run and long-run with a precision that is often missed in ordinary
discussions. This distinction is not based on the duration of time but on the ability of the business firms to
change the use of the different inputs such as raw material, labor, management, plant and equipment etc.

If firms can change the ratio in which every input is used, the period is referred to as the long run. On the
other hand, if firms can change the use of a few inputs but not all, the period is referred to as the short run.

In real life this type of dichotomy between long-run and short-run perspectives breaks down. In many
decisions as the time perspective is extended more and more items of costs become variable. Revenue items also
are likely to change as the time perspective moves out farther. The crucial problem in decision-making is to
maintain the right balance between the short run and long run and intermediate run considerations, but may as
time passes, have long run repercussions that make it more of less profitable than it seemed at first. The
following illustration may make the matter clear.

Consider a firm with some temporary idle capacity. An order for 10,000 units comes to the management’s
attentions. The prospective consumer is willing to pay Rs. 4 per unit or Rs. 40,000 for the whole lot. The short
run incremental cost (which ignores the fixed cost) is only Rs. 3 . Therefore, the contribution to overhead and
profit is Re.1 per unit (or Rs. 10,000 for the whole lot). In spite of this favorable position, before accepting this
order, the management must take into consideration the following long run repercussion viz.,
 1. Firstly, if the management commits itself to a series of repeat orders at the same price the management
may be forced to consider the question of expansion of capacity when the so called fixed costs may also
become variable.

2. Secondly, the acceptance of an order at a lower price might tarnish the image of the company.

3. Thirdly, some of the present customers may feel that they had been treated unfairly and may opt to resort
to firms which follow ‘ethical pricing’.

The above considerations lead us to following conclusion. A decision should take in to account the short run and
long run effect on revenue and cost, customer reaction and company’s image etc, giving appropriate weight to
the most relevant time periods.

The Discounting Principle

Money has a time value. A certain sum of money, say Rs 1000 to be received today is worth more than Rs
1000 to be received in future. But how much is it worth depends upon two factors which are, (1) The time
interval (2) The time pattern

The proverb ‘A bird in the hand is worth two in the bush’ is applicable to this concept. Suppose a person
is offered a choice whether to receive Rs 1000 today or Rs 1000 next year. Naturally he will choose the first
offer for two reasons.

First, the amount can be invested and made to earn interest. Second, a lot of risk and uncertainty is involved in
recovering the amount in future. Considering these, business firms always prefer receiving a given amount that
day itself to receiving the same amount in future.

Investment in business leads to an accrual of benefits over a period of time. The computation of the
present value of an amount due in future or stream of earnings likely to accrue in future, involves discounting of
time.

Suppose we have Rs.2,000 at our disposal. We can invest this amount in a bank, say at an interest rate, ‘r’
of 10%. After one year, we could withdraw from the bank both the original deposit and the accumulated interest;
this would be our future receipt in year one, or R1.

That is, R1= Rs2000 + (0.1)2000 =Rs 2200

 Generally R1=PV +r(PV) = PV(1+r)

Where PV = present value

Alternatively if we do not withdraw the money but leave it on deposit for a further period of one year,
then at the end of the second year we could withdraw the following.

R2 = R1 +r(R1) = R1(1+r) = PV(1+r)2

In this manner, R at the end of year ‘n’

Rn = PV(1+r)n

This process is called compounding. The above compound interest formula tells us about the magnitude of
a future receipt if we already know its present value and the interest rate.

The reverse procedure, where the future receipt and the interest are known, and the present value can be
found out. It is known as discounting.

The discounting formula can be stated as:

PV =Rn(1+r)n

This gives us the PV of a sum of money to be received ‘n’ years hence, at a given discount rate of ‘r’. When a
stream of future receipts is expected, to accrue at annual intervals, then the PV of a stream is the sum of the PVs
of each receipt. That is

R1/(1+r) + R2/(1+r)2+ R3/(1+r)3..................+ Rn/(1+r)n

Suppose a firm is going to receive Rs 20000 per year for the next three years at a rate of 10% from its fixed
deposit. Then

PV= 20000/(1+0.10) + 20000/(1+0.10)2+20000/(1+0.10)3

= 20000/1.10 + 20000/1.21 + 20000/1.301

= 18180.2 + 16529 + 15026.2 = Rs 49735.4

The Concept of Opportunity Cost

The concept of opportunity cost lies at the heart of all managerial decisions. The opportunity cost of anything is
the alternative that has been forgone. This implies that one commodity can be produced only at the cost of
foregoing production of the other.
Smith has observed, if the hunter can bag a deer or a beaver in the course of a single day, the cost of a deer is a
beaver and the cost of a beaver is a deer”.

In managerial economics, opportunity costs are the costs of displaced alternatives. They represent only
sacrificed alternatives. According to Haynes, Mote and Paul.

1. The opportunity cost of funds tied up in one’s own business is the interest that could be earned on those
funds in other ventures.

2. The opportunity cost of the time one puts in his own business is the salary he could earn in other
occupations.

3. The opportunity cost of using a machine to produce one product is the sacrifice of earnings that would b
possible from producing other products.

4. The opportunity cost of using a machine that is useless for any other purposes is nil, since its use requires
no sacrifice opportunities.

4.6The Principle of Equi-Marginalism:

According to this principle, if an input can be used in producing goods or services, the allocation of the input
should e such that its marginal contribution is the same in all its uses.

Let us explain this concept with an example. Suppose a firm is engaged in 4 activities –A,B,C and D. All these
activities require the services of labour. Imagine that the firm has 100 units of labour at its disposal, and this is
fixed , as the total pay roll is predetermined. The firm can enhance any one of its activities by adding more
labour but only at the cost of labour in its other activities. The optimum will be attained when the value of the
marginal product of labour its equal in all activities.

Symbolocally

VMPla=VMPb=VMPlc=VMPld where

VM P=value of the marginal product.

L=labour

A,B,C and D=Activities.

This concept of equi-marginalism is crucial in capital budgeting , where the limited resources of the firm have to
be allocated in a rational manner. The equi-marginalism concept holds good only in cases of diminishing
returns.

REVIEW QUESTIONS:

1. Define decision-making?

2. What are the fundamental concepts that aid the decision-making process?

3. What are the objectives of a business firm

4. State the incremental concept and explain its importance.

5. Briefly explain the 5 principles which are basic to the entire gamut of managerial economics.

6. What is opportunity cost? How is it calculated?

7. Show that the principle of ‘Equi-Marginalism’ is the extension of the condition of equilibrium of a
consumer.

8. Write short notes on

a. Discounting principle

b. Marginalism

c. Steps in decision-making