Micro 18 - Business objectives and Economic efficiency

Question 1

What is a shareholder?

Answer 1

A shareholder is someone who legally owns a part of a company

Question 2

What rights does a shareholder of a company have?

Answer 2

They have the rights to:
- Attend general meetings
- Possible receive a share of the profits
- Usually a board of directors would decide what portion of profits to reinvest and what amount to give back to the shareholders as dividend. A shareholder would get 1% of the amount allocated to dividends

Question 3

What would a shareholder lose if the firm went bankrupt?

Answer 3

If the firm went bankrupt you would lose the amount invested in the shares but no more, your own personal assets wouldn’t be at risk

Question 4

What is a Publicly limited company (plc)?

Answer 4

A plc is a company in which its shares are for sale publicly meaning anyone with the money can buy shares from the stock exchange

Question 5

What is a privately limited company (ltd)?

Answer 5

An ltd does have shareholders despite being privately limited. This means not everyone can buy shares in these companies. Permission would need to be gained from existing shareholders to buy into the business

Question 6

When do shares raise money for a business?

Answer 6

Shares raise money for a business when the shares are initially sold. If you then buy the shares from someone else this does not raise money for the business

Question 7

What are some reasons why a firm want to keep its shareholders happy?

Answer 7

• For PLCs the share price is determined by demand and supply. If the business is thought to be doing badly many people will sell their shares and demand for buying these shares will be low as investors will not expect a dividend. This leads to supply shifting right and demand shifting left resulting in a lower share price. This is bad for a firm as a lower share price could make them a target for takeover possibly meaning job losses and the board of directors being replaced
• Unhappy shareholders may also make it difficult to raise more share capital in the future from selling new shares. Shareholders may not approve of this decision which could mean the firm have to resort to an expensive bank loan instead

Question 8

What are the main general business objectives for firms?

Answer 8

• Profit maximisation
• Revenue maximisation
• Sales maximisation
• Profit satisficing

Question 9

Describe profit maximisation as a business objective

Answer 9

Profit maximisation is the objective for a firm to make as high level of profit as possible and so firms may choose to produce the level of output to profit maximise at MR=MC

Question 10

What are some of the reasons a business may choose to pursue profit maximisation as an objective?

Answer 10

• Profit maximisation is a rational business objective to follow and will satisfy shareholders - dividends
• Happy shareholders will mean they are not keen to sell their shares. This will mean the share price will remain high and the firm is at less risk of takeover
• Keeping shareholders happy is likely to mean raising more money from issuing shares in the future is easier
• Profit maximisation leads to high levels of profit for reinvestment. These profits can be used to improve efficiency through buying more efficient capital goods for example

Question 11

What are some of the reasons a business may not choose to pursue profit maximisation as an objective?

Answer 11

• Profit maximisation is difficult as it involves precise knowledge of marginal revenue and marginal cost. This is difficult to know and firms may need to calculate it using trial and error. Even if a firm does know this information, in quickly changing markets this information may soon become out of date
• High profits may attract new entrants into the market
• They may not be private sector businesses as public sector organisations are unlikely to have profit maximisation as an objective
• They may want to avoid attention or investigation from competition authorities so may keep profit lower than they could
• Profit maximisation can neglect other stakeholders such as employees who are essential for the long term success of the business
• Profit maximisation could involve cutting corners - quality or safety

Question 12

Describe revenue maximisation as a business objective

Answer 12

Revenue maximisation is an objective that occurs where a firm produces where marginal revenue is zero to achieve the highest possible level of total revenue

Question 13

What are the reasons why a firm may choose to maximise revenue as a business objective?

Answer 13

• Market share
• Brand loyalty
• Divorce of ownership and control - managerial reasons
• To avoid attracting attention of competition authorities

Question 14

Describe sales maximisation as a business objective

Answer 14

Sales maximisation occurs when a firm sells as many units as possible without making a loss and this occurs where average revenue is equal to average cost (AR=AC)

Question 15

What are the reasons a business may aim to maximise sales as a business objective?

Answer 15

• Public sector organisations may pursue this
• To survive
• To create brand loyalty
• To increase market share and exploit economies of scale
• To reduce levels of competition

Question 16

Define predatory pricing

Answer 16

Predatory pricing is when prices are deliberately set below costs by a dominant firm to drive out competition. In the short run the firm will make a loss, however in the long run the firm will increase prices and make higher levels of profit due to a reduction in competition

Question 17

Define limit pricing

Answer 17

Limit pricing is when prices are deliberately set very low by a dominant competitor in the market in order to restrict or prevent competition. Here the existing (incumbent) firm exploits its economies of scale and charges a price below the cost of production of a potential entrant

Question 18

Describe profit satisficing as a business objective

Answer 18

Profit satisficing is a potential business objective which occurs when a firm makes a reasonable level of profit that satisfies its stakeholders without maximising profit. This means there is likely to be a quantity and price somewhere between profit maximisation and sales maximisation

Question 19

What are a few examples of stakeholders in a business?

Answer 19

• Shareholders
• Managers
• Consumers
• Workers
• Government

Question 20

Define stakeholder

Answer 20

A stakeholder is a person with an interest in the activities of a business

Question 21

Why may a business choose profit satisficing as an objective?

Answer 21

• Shareholders want profits since they earn dividends from them
• Managers might not aim for high profits, because their personal reward from them is small compared to
  shareholders. Therefore, managers might choose to earn enough profits to keep shareholders happy, whist still meeting their other objectives

Question 22

What is the principle-agent problem?

Answer 22

The principle-agent problem occurs when one group, the agent, is making decisions on behalf of another group, the principal. In theory, the agent should maximise the benefits for those whom they are looking after but the problem arises when the aims of the manager (agent) and the principal (shareholder) differ

Question 23

What is the divorce of ownership and how is it related to the principle-agent problem?

Answer 23

The divorce of ownership occurs when in a large business the owners hire staff and managers to run the business for them instead of running it themselves therefore the divorce of ownership is a cause of the principal-agent problem

Question 24

What are the three different types of economic efficiency?

Answer 24

• Productive efficiency
• Allocative efficiency
• Dynamic efficiency

Question 25

Define static efficiency

Answer 25

• Static efficiency is concerned with the most efficient combination of resources at a given point in time
• Static efficiency focuses on how much output can be produced now from a given stock of resources and whether producers are charging a price to consumers that fairly reflects the cost of the factors of production used to produce a good or service

Question 26

What are the two types of static efficiency?

Answer 26

Allocative and productive

Question 27

Define productive efficiency

Answer 27

• Productive efficiency involves using the least possible amount of scarce resources to produce the maximum output
• For a firm this occurs when it is producing at the lowest average cost - it is producing at the minimum efficient scale

Question 28

Define allocative efficiency

Answer 28

Allocative efficiency occurs when scarce resources are used to produce a bundle of goods which satisfies consumer preferences and maximises their welfare. It occurs when price is equal to marginal cost

Question 29

Define dynamic efficiency

Answer 29

Dynamic efficiency looks at how over the long term new technology and productive techniques can increase the productive potential of firms

Question 30

How is dynamic efficiency achieved?

Answer 30

Dynamic efficiency is achieved when firms are able to reinvest any supernormal profits into more efficient capital to either reduce production costs or by improving non price factors

Question 31

What is X-inefficiency?

Answer 31

X-inefficiency arises because a firm fails to minimise its average costs of production at a given level of output. Average costs are higher than they would be with competition. A firm may have little incentive to control costs due to a lack of effective competition in the market

Question 32

What are the possible causes of X-inefficency?

Answer 32

• Monopoly power - A monopoly faces little or no competition therefore it might be easy for the monopolist to make supernormal profits. Therefore in the absence of competitive pressures they may not very hard to control costs
• State control - A nationalised firm owned by the government may face little or no incentive to try and make profit therefore it has less incentive to cut costs
• Management may be poor at controlling costs
• Directors and managers might pay themselves and take bonuses in excess of what is needed to keep them employed at the firm - easily done when there is divorce of ownership
• Trade unions might be able to negotiate higher rates of pay than the market wage rate