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Profit is obtained by subtracting total cost (TC) from total revenue. Under the assumption of the neoclassical theory, a firm will aim to produce a level of output where the difference between the total revenue and total cost is the greatest as mentioned by Holcombe (2009) whom supported Pindyck and Rubinfeld’s explanation. “The maximisation of TR-TC is the equilibrium condition for a profit-maximising firm” (Powell, 2009). This is because once the firm is getting the most profit from a particular level of output and sales, it will not be incentivised to alter the level of output that is giving it the most yields in total investment performance.
A firm which strictly follows the primary assumption of the neoclassical theory of the firm will make its decisions on inputs and outputs based on the marginal effects of the components in the profit equation. Thereby leading economists to arrive at the conclusion that the condition for profit maximisation to be achieved is when marginal revenue and marginal cost are equal, in other words, total profit reaches its maximum point where MC and MR intersect. This is also known as the second order condition. Perloff says, “To maximize profit, all firms (not just competitive firms) must make two decisions. First, the firm determines the quantity at which its profit is highest. Profit is maximized when marginal profit is zero, or, equivalently, when marginal revenue equals marginal cost. Second, the firm decides whether to produce at all” (Holcombe, 2009).
MC = MR means that a firm’s profits are the largest when the extra revenue gained from one more unit sold is exactly equal to the extra costs incurred from production the additional unit of output. A firm in a perfectly competitive market is a price taker. Regardless of the amount of output it sells, it cannot influence the market price so marginal revenue will be equal to average revenue, demand and price. In Diagram 1.1, Q1 is the profit-maximising level of output and P is the profit-maximising price. When a firm produces less than output Q1, marginal revenue exceeds marginal cost. The firms may then gain more profit by increasing its output. However, producing any output beyond point Q1 results in marginal cost being greater than marginal revenue. Consequently, the firm would be experiencing losses and may subsequently resort to reducing its output up to point Q1 where marginal cost and marginal revenue are equal. In other words, producing any more would incur more costs than the revenue generated and producing any less would result in the loss of potential profits. Thus, it can be concluded that a firm’s profits are maximised at a level of output where its marginal revenue exactly covers its marginal cost.
Take for example, a small-time farmer growing chickens to be sold at a market nearby. There are many farmers alike so he is unable to influence the market price for chickens at 2 pounds per kilo. No matter how many kilos of chickens he sells, his average revenue and marginal revenue are equal at 2 pounds. Suppose that when a large exporter who grows chickens on a bigger scale sells 100 kilos of chicken on the market, the cost of producing and selling the 100th kilo is 1.60 pounds. Should the farmer decide against selling the 100th kilo, he loses 40 pence of profit. However, suppose that when a 101th kilo and 102nd kilo are marketed, total costs increase to 2 pounds and 2.40 pounds respectively. The marketing of the 102nd kilo results in profits falling by 40p whereas the 101th kilo does not affect the total profits. Therefore, the 101th kilo is the quantity sold at which profits are exactly maximised.
Profit-Maximisation vs. Shareholder Wealth
It is important to distinguish between profit maximisation and shareholder wealth. The former is seen as a short term goal, to be achieved within a given period of time whereas the latter is more of a long-term objective. From the World Academy Online article, “A corporation may maximize its short-term profits at the expense of its long-term profitability” (World Academy, 2012). In the short-run, decisions are made to ensure that profits are maximised, even at cost of the firm’s sustainability of survival in the long-run. For example, the company Purdue Pharma who manufactured a powerful narcotic painkiller OxyContin marketed the drug and claimed that is was not addictive even though the company’s executives knew it was a false claim. The company’s motive behind this unethical act was to boost sales and maximise profit in the short-term. However, this came at the expense of the company as Purdue Pharma and its executives were convicted of criminal charges and fined heavily (Miller, 2012). The company was destroyed in its effort to fulfil its short-term objective. Shareholder wealth is regarded as a long-term objective because shareholders are concerned about profits now as well as in the future and are therefore, interested in the sustainability of the firm.
In large corporations, the firm is run by directors and managers who are answerable to shareholders. Those who run the firm may not have interests, vision or goals that align with those of the shareholders (Berle & Means, 1932). “This perception is aided by recent news of the 25-year jail sentence handed down to former World.Com boss Bernard Ebbers for his part in the fraud that caused the $11 billion collapse of that company” (McConvill, 2005). They may prioritise maximising short-term profits or even to maximise sales revenue (Baumol, 1958) as they may be driven by self-interest. “In agency theory, the agent may be succumbed to self-interest, opportunistic behaviour and falling short of congruence between the aspirations of the principal and the agent’s pursuits” (Abdullah & Valentine, 2009). Some firms pay their managers bonuses based on the year’s sales revenue or reward them with non-monetary benefits such as creature comforts. Ergo, higher sales revenue for the year means a bigger bonus or more benefits for this group of people. Shareholders on the other hand tend to be keener on the firm’s profitability in the long-run to ensure continuous returns on their investment. Managers do not stand to benefit directly from shareholder wealth maximisation unless they own shares in the company itself. Thereby, giving rise to conflict between shareholders who own the firm and managers who run the firm. “This conflict is called the principle/agent problem” (Peavler, 2012). This reinforces the view that under such circumstances, tension does exist to a certain extent.
To enable long-term profit maximisation or shareholder wealth, short-term profit maximisation may have to be forgone. Thus, tension may arise between these two objectives. This is so because investments, new capital, innovations, research and development for example, could assist in long-term growth and profitability and hence, maximising shareholder wealth. However, in order to finance these long-term profit-making means, short-term profits may have to be sacrificed. On top of that, short-term profit maximisation does not take risk into account and tends to neglect social responsibility which many economists would deem as necessary in pursuit of shareholder wealth maximisation in the long run. High risk decisions may be considered favourable a long as they promise high returns even if they jeopardise the company’s image or well-being. Large banks especially those in the US were often used as proof of this matter when they made socially irresponsible and risky decisions by investing in sub-prime mortgages and derivatives. Whilst they made profits in the short-run, shareholder wealth was far from maximised in the long-run. Consequently, these banks suffered and many failed as backed by the extract from the New York Times. “Funds and banks around the world have taken hits because they purchased bonds, or risk related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or C.D.O.’s” (NY Times, 2007).
On the contrary, there might not be tension between these two objectives if short-run profit maximisation was not the firm’s primary objective or if it was complementary to the long-run shareholder wealth objective. Theoretically, firms are assumed to possess information, market power and the incentives to determine output as well as pricing that would optimise profits. In the real world, firms are always faced with imperfect information about demand and cost conditions and uncertainty. Under such conditions, a firm may be contented with satisficing profits while making enough to ensure the ongoing growth and development of the firm which would contribute to shareholder wealth in the long-term. Large firms especially, have complex structures in which profit-maximisation is a much too simple assumption to be made. Consequently, such firms would have other objectives on the top of their list such as revenue maximisation, managerial utility maximisation or maybe even seek to satisfice each goal rather than maximise as depicted by behavioural theories of the firm. However, it may be argued that shareholders would support the profit-maximising goal and in return, the profits made would be reinvested in new investments, innovations and R&D projects. With respect to this theory, the more profit the company makes, the more funds are available for purposes which would enhance the value and price of the company’s shares in the future and hence, shareholder wealth.
Whether or not tension or conflict exists between short-run profit maximisation and long-run shareholder wealth depends on several factors which ought to be taken into consideration. The size of the firm and its position in the market in terms of market share for example, could influence the nature and priority of its objective(s). The firm’s objective(s) may change in order of importance depending on the economy’s business cycle and health and the firm’s past and present performance. Firms may adjust the priority of their objectives in a quarterly or annual basis to suit current developments and progress of the firms of the firms with respect to their competitors. Also, different firms have a different structure and degree of complexity, governed by different groups of directors, managers and shareholders – all of which would influence their main objective. There is also the possibility that some modern-day firms follow a range of objectives and seek to satisfice rather than maximise as suggested by Cyert & March’s behavioural theory (Argote & Greve, 2007). In large firms, the extent of divorce between ownership and control would influence the severity of the principal-agent problem when it exists. Some firms exhibit characteristics of Oliver E. Williamson’s model of managerial discretion which implies that managers design and implement policies in discretion to maximise their personal utility instead of aiming for the maximisation of profits which at the end of the day, maximises shareholder wealth (Williamson, 1963).
Does tension exist between short-run profit maximisation and long-run shareholder wealth? Well, it depends. The neo-classical model of profit-maximising holds to a certain extent but in the real world, its assumptions are too simplistic to be coupled with the complexity of firms. Upon breaking down the assumptions of the neo-classical theory of the firm, profit-maximising as the ultimate goal of firms may not be as logical as it seems. “The neoclassical model is unsatisfactory, I believe, not only because its assumptions are unrealistic, but also because it misinterprets human action within the setting of the firm” (Anderson, 2003). When shareholder wealth depends upon profits made in the short-run, the two objectives may be conflicting. In order to achieve shareholder wealth maximisation, managers may have to make corporate decisions which would come at the expense for short-term profits. On the other hand, the two objectives can be a complement of the other if profits made in each time period are independent of each other. Short-term profit maximisation could ultimately lead to long-term profit maximisation and thus, shareholder wealth maximisation. It is also possible that there may be little or no tension if profit maximisation is not the firm’s main goal. Moreover, there are other alternatives which may be more viable and realistic in practice such as managerial utility maximisation (Williamson), sales revenue maximisation (Baumol), and objectives satisficing (Cyert & March) or even a behavioural alternative. Either of these could go against long-run shareholder wealth and pose even greater threat to shareholders wealth.
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