3.5.2 - The Objectives of Firms

Question 1

What does traditional theory assume about entrepreneurs who run firms?

Answer 1

To maximise profit by producing the optimal output.

Question 2

What is the equation for total profit?

Answer 2

Total revenue - Total Cost

Question 3

What does profit maximisation look like in an equation?

Answer 3

The point at which TR - TC is maximised.

Question 4

What equation can find when profit has been maximised?

Answer 4

When MR = MC.

Question 5

What does MR = MC actually mean in practice?

Answer 5

A firm’s profits are greatest when the addition to sales revenue received from the last unit sold (marginal revenue) is equal to the total cost incurred from making the last unit (marginal cost).

Question 6

Give and explain an example of MR = MC in the real world?

Answer 6

If the ruling market price is 50p per kilo of flour, at any output, the average revenue is 50p per kilo, meaning marginal revenue is also 50p.

Suppose a miller markets 400 kilos of flour, the cost of producing and marketing the 400th kilo is 48p. There is 2p of profit per kilo left. If the 402nd kilo is 52p, there is 2p of profits lost. If the 401st kilo is 50p to market and produce, the marginal cost is equal to the marginal revenue of 50p, meaning profits have been maximised.

Question 7

What happens to profits when MR > MC?

Answer 7

Profits rise as output increases.

Question 8

What happens to profits when MR < MC?

Answer 8

Profits rise as output decreases.

Question 9

What should a firm do when MC < MR?

Answer 9

Increase the output.

Question 10

What should a firm do when MC < MR?

Answer 10

Reduce the output.

Question 11

What should a firm do when MC = MR?

Answer 11

Nothing, profit has been maximised at their current size.

Question 12

How does a firm maximise profits in any market structure?

Answer 12

Ensure that MC = MR.

Question 13

What is the divorce of ownership from control?

Answer 13

The owners and those who control the firm are different groups with different objectives.

Question 14

Do small firms experience a divorce of ownership from control?

Answer 14

No, the entrepreneur tends to be the owner.

Question 15

Do large firms experience a divorce of ownership from control, and if so, why?

Answer 15

Yes.

Medium and large sized companies are often owned by thousands of shareholders, with a select few owning the majority.
Despite the firm being owned by shareholders, they do not decide what happens with the company as executive directors decide what to do.

Question 16

What power can shareholders exercise over a large company?

Answer 16

They can oust poorly performing executives.

Question 17

What is the largest problem stemming from divorce of ownership from control?

Answer 17

The possibility that directors and managers may pursue their own agenda that is not in tune with the shareholders.

Question 18

What is the name given for directors not pursuing the same goals as shareholders?

Answer 18

The principal-agent problem or the agency problem.

Question 19

How does the agency problem present itself in the real world?

Answer 19

The shareholders main goal is to maximise profits. However, managers and directors may choose to maximise career prospects.

Question 20

Why does the agency problem present itself?

Answer 20

When a principal delegates a task to an agent, the agent bears the cost of fulfilling the objective but does not receive the full benefit of their actions.

The agent has no incentive to put the same effort into the task as if the agent was doing it on their own behalf.

Question 21

What attempts to solve the agency problem for agents by principals?

Answer 21

If an agent does well, they are rewarded with larger and larger bonuses.
However, if they do poorly, they can be fired or removed as the principals will have lost a large sum of money.
Financial carrot or stick.

Offer the agent company shares so they take some of the profits as if they were a principal.

Question 22

Why can an agent get away with not acting in the best interest of the principal?

Answer 22

The cost of removing the agent may be too high relative to the benefit for the principal.

There is an asymmetry of information between the agent and the principal as the agent often knows more about the market than the principal. It is difficult to pin blame on an agent if the principal is not fully aware as to why it happened.

Question 23

Why does the financial stick not work every time?

Answer 23

Most agents are rewarded with huge pay-offs when they are let go.

Question 24

What are the possible business objectives other than profit maximisation?

Answer 24

Growth maximisation.
Sales revenue maximisation.

Question 25

Why could growth maximisation be a business objective?

Answer 25

Usually, the continued growth of a business leads to achieving economies of scale with their associated cost reductions.

Question 26

Why can sales revenue maximisation be a business objective?

Answer 26

Firms may try to maximise sales revenue when managerial pay is liked to revenue rather than profit.

A manager may elect to maximise revenue if their personal revenue is maximised.

Question 27

What is the equation for revenue maximisation?

Answer 27

Where MR = 0.

Question 28

What is the important distinction between revenue maximisation and profit maximisation?

Answer 28

Revenue maximisation is the point at which a firm continues producing goods until MR is at or above 0.

Profit maximisation is the point at which a firm has their MR = MC.

Question 29

What is satisficing?

Answer 29

Achieving a satisfactory outcome rather than the best possible outcome.

Question 30

What do behavioural economists see a firm as?

Answer 30

An organisation comprising of different groups in a firm each with different group objectives.

Question 31

What are the groups in a firm known as?

Answer 31

Stakeholders.

Question 32

Why do firms satisfice?

Answer 32

The different stakeholders in the firm have different objectives.

Managers may seek power and prestige.
Shareholders attempt to maximise profits and minimise wage costs.

Satisificing involves managers maximising status and power, while still delivering a satisfactory level of profit for shareholders.

Question 33

What does satisficing mean in terms of targets?

Answer 33

Targets will likely be minimum targets rather than maximum targets.

Question 34

Where is satisficing likely?

Answer 34

Monopolies.
Firms in imperfectly competitive markets.

Question 35

How may a monopoly satisfice?

Answer 35

Managers may settle for satisfactory profit alongside some inefficiency.

Question 36

Why can firms in perfectly competitive markets not satisfice?

Answer 36

The entry of new firms cause incumbent firms to remove any unnecessary costs or risk going bankrupt.

Question 37

What does traditional economic theory assume about a firms business objectives?

Answer 37

Only one, profit-maximisation.

Question 38

What point is profit maximised?

Answer 38

The point where MR = MC.