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Profit Maximization Theory

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Profit Maximization Theory essay
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In this assignment, I will focus on different objectives that a business may have, including whether profit maximisation is always the objective of a firm. I will take into account alternative aims a business may have depending on a range of factors and responsibilities.Profit maximisation is when a business is making as much profit as it possibly can and it achieves this when marginal revenue is equal to marginal cost. To assume a businesses actions are guided by profit maximisation is a common economic theory. Profit maximisation is the original objective of a firm, but it is assumed that there is no separation between the managers in charge of running the business and the owners of the business meaning the firm is run by the owners (Griffiths & Wall, 2011).

This is most common in Sole Trader businesses and Partnerships, however very uncommon in Limited Companies. If a company aims to meet shareholder interests, then the profit maximisation theory is supported as ‘the discounted flow of profits will be equal to the share price’ (Black, 2017). In Limited companies, shareholders, who are the owners of the company (Principals), often employ managers (agents) to run the business on a day to day basis. Due to this, some difficulties are encountered.

The difficulties include the principal-agent problem, which is when owners are unable to ensure their objectives are being carried out by the managers, due to a lack of knowledge (Sloman, 2015). This causes an asymmetric information problem, because owners are unable to observe day to day decisions that are made by the managers in charge, then the owners are unaware that profits are not being maximised. This makes most companies profit-seekers and not profit maximisers as managers still want to make profit for the business but can be more focussed on long-term or other short-term objectives.

There are several decisions that a company can choose to take to ensure that a principal-agency problem does not occur. One way of doing this is by creating an Employee Share Ownership Scheme. This is when the employees of a company receive shares in that company, making them part owner. Companies like John Lewis and Waitrose provide these schemes and this would prevent a principal-agency problem from occurring as the managers of the business will also be part owners. This means that the managers will share the same interests as the other shareholders of the business and run the business with these common goals in mind.

Another way a company can prevent this problem is by offering the senior managers of the company long term contracts. By offering management a 5-10 year contract, it will encourage the managers to put long-term interests of the business before short-term interests. As owners of a company want long-term success, this will mean both the owners and managers objectives are similar. A system a company could use to to prevent a principal-agency problem is corporate governance. This is a way in which companies are able to be controlled and the owners put this governance in place by appointing people as a board of directors, who will set aims and provide leadership, also the owners will employee auditors to report to the on the stewardship of the managers. Corporate governance aims to have the shareholders interest as the main objectives of the firm (CIMA, 2017).

Not every business aims to maximise profits, as different managers have different objectives depending on behaviour. One theory of this is Williamson’ theory of utility maximisation. He argues that managers are free to choose what goals to aim for as long as they achieve satisfactory profit for the owners. Williamson then found that there was one measurable factor ,which is salary, and three unmeasurable factors, including dominance, professional excellence and job security (Sloman, 2015). Another theory is the sales revenue maximisation theory, developed by Baumol. Managers may be deemed successful if they achieve a specific sales revenue amount. The prestige, power and salaries of managers may rely on this, for example, commission may be paid to managers that reach a certain level of sales revenue. This would mean that profit maximisation would be less important to the managers of a firm than maximising sales revenue (Sloman, 2015).

Another objective managers may have is to grow, as Marris, if managers increase ‘the empire’ they have built, then their status will to improve. Marris would also suggest that growth is an end, however, people argue that growth will only get a business so far, therefore saying that there is more important objectives to a firm (Griffiths & Wall, 2011). They are all examples of a managerialistic behaviour, where as a behaviourist approach would say that managers are willing to compromise on their objectives to please the owners by getting satisfactory profits.Businesses that aim to maximise profits are sometimes criticised for a number of reasons.

One criticism of profit maximisation is that it is a very short term plan strategically, so a business may be better setting more long-term objectives, for example growth and expansion. Another criticism of profit maximisation is that it may have consequences on the perception of the business. This is because the business would be looking to cut costs, which may mean being unethical. Ethics is concerned somebody should act in a given situation, so if a business mad the wrong decision to use less quality goods then it is an unethical decision (CIMA, 2017). This could give the business a bad name and decrease demand for the goods, causing the business to lose sales. Also, a business has many different ‘discrete groups’ that are interested in the actions of a business, so if a business is aiming to maximise profits then its only focusing on the shareholders (owners) of the company, and not the various other stakeholders involved (CIMA, 2017).

In conclusion, I believe profit maximisation is not the only objective for a firm as there are many different potential objectives, problems that occur like the principal-agency problem and many criticisms towards profit maximisation as the only objective of a firm.

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