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Maximisation of profits Essay

“The increased rate of merger activity both nationally and internationally suggests that many enterprises will adopt a multi-divisional internal structure. The implication of this divisionalisation must be that modern business firms are more likely to adopt goal pursuits and least cost behaviour associated with the neo-classical profit maximisation hypothesis. ” Many would make the basic assumption that firms are in business for a simple reason: To make money. Traditional economic theory suggests that firms make their decisions on supply and output on the basis of profit maximisation.

However many Economists and managerial Scientists in our days question that the sole aim of a firm is the maximisation of profits. These economists suggest that there are a number of other objectives that are important to a business. Personal motives may be important, especially where the manager is also the owner of the firm. In this case emphasis may be placed on good employee relations and the welfare of the workers. Divorce of ownership from control in modern day businesses has challenged the traditional theory of economists that profit maximisation is the main objective.

Many businesses, especially those involved in merger activity are beginning to move away from the traditional U (unitary) form organisation,

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and towards the M form (multi divisional). U form businesses have a hierarchy with a chief executive (or equivalent) at the top, and then the next layer is the different functional areas such as marketing, or finance. In many ways, this organisation is ‘natural’ and permits economies of scale and efficient division of labour, provided the chief executive has sufficient control. As U form enterprises expand, internal efficiency may be reduced due to a loss of control.

Eventually strategic decision-making is at risk from deviating from the firm’s core objectives. This is why many expanding businesses (including mergers) are moving towards ‘M’ form structures as it allows a tighter control over business activities. The ‘M’ form structure involves having many different layers each of which have their own objectives. Instead of making all planning and strategic decisions, the main operating decisions are left to the individual sub units, leaving the executive staff to plan and provide an advisory role.

A ‘M’ form firm (especially a large corporation) is not a single decision-maker, but a collection of people within it. In order to understand the decision-making process within firms, one would have to analyse who controls the firm and look at what their interests are. Most large companies are not run by the their owners, large corporations are typically owned by thousands of shareholders, most of whom have nothing to do with the business decisions. Those decisions are made by a professional management team, appointed by a salaried board of directors.

In most cases these managers will not own stock in the company, which may lead to strongly differing goals of owners and managers. The neo-classical theorists argue that firms only exist to ‘profit maximise’ regardless of size. “A business firm is an organisation designed to make profits, and profits are the primary measures of its success… profits are the acid test of the individual firms performance. ” Joel Dean 1951. (Bized website). Modern economists would argue that this theory is out dated and was created in a time when small businesses were run by the owner who relied on the business for their income.

In today’s business environment there are many more external influences such as legislation which affects the running of the business. However neo-classical economists point out that at some point the majority of business objectives (that are not to maximise profits) will inevitably all lead back to the profit maximisation theory. For example, if the objective was growth maximisation, one could argue that you cannot grow your business unless you are profitable.

To grow you will need resources which you can get by either re-investing profits or by borrowing money in which case the bank or institution is likely to look closely at the profitability of a firm before making its decision. There are many alternative to the neo-classical profit maximisation theory that challenges their ideas. Sales Revenue Maximisation is one of these alternatives. This objective was initially developed by the work of Baumol (1959). Baumol’s research focused on the behaviour of manager-controlled businesses – where the day-to-day decisions taken by managers are divorced from the shareholders (the owners of the business).

Baumol argued that annual salaries and other perks might be more closely correlated with total sales revenue rather than profits. It could be argued that if your sales are maximised then your revenue is likely to rise at a faster rate than your costs (as you can exploit economies of scale more) and the end result of this is likely to be an increase in profits. Another alternative view was put forward by Williamson (1963), who built a model based on the concept of managerial satisfaction (utility).

This model is similar to Baumol’s sales revenue maximisation in the sense that managers try to maximise their own utility subject to some profit constraint. Managerial utility includes high salaries, perks, status, and power and job security. These factors provide the basis for managers to spend money on staff. This can be enhanced by success in raising sales revenue. Total revenue is maximised when marginal revenue = zero. The shareholders of a business may introduce a constraint on the price and output decisions of managers – this is known as constrained sales revenue maximisation. (Bized website).

They may introduce a minimum profit constraint designed to underpin the market valuation of their shares and maintain a dividend (a share of the company’s profits). Again it could be argued that this leads to an eventual increase in profits, as it would be difficult for managers to receive these perks or give them to employees unless the business is successful. Shareholders often look at the profitability of a firm when assessing how successful a business is. There are a number of characteristics shared by the neo-classical and managerial models, the main one being that they are both maximisation theories.

An alternative to these is the Behavioural model. This model was built on the work of behaviourists Simon (1959) and Cyert & March (1963). This model stresses the internal organisation of companies, attention is focused on the behaviour of a firm which is seen as a set of groups, each of which has their own set of objectives. Behaviourists argue that it is inevitable that there will be conflicting views between departments. For example the finance dept may wish to keep stock levels to a minimum to reduce holding costs, whereas the sales dept may wish to keep high stock levels so that they can always meet customer demands.

They claim that businesses don’t aim to maximise anything and instead aim for a satisfactory business outcome. This is known as ‘Satisficing Behaviour’. Saticficing concentrates on the compromises between each department. The behavioural model also emphasises the belief that many organisations are extremely complex and that those individuals that make decisions have limited knowledge concerning internal and external developments especially in other departments.

This model is critisied heavily for its disregard to the businesses external environment. Many believe that if you do not respond to your external environment then it may lead to difficulties in surviving and competing. However many accept the model for its realistic approach to the differing objectives within a business. James Early spoke at an American economic conference in 1957, and he offered a compromise between the maximisation and satificing models. He believed that businesses strive for “the highest practical level of profit.

” He stated that business would like to profit maximise but there are constraints and so they would have to settle for the highest level possible. So if businesses were able to they would be profit maximisers. (Harvey, J, Mastering Economics). The behavioural model is a more accurate description of what happens inside a firm, however with a continued growth in the number of large corporations through merger activity, most who adopt the ‘M’ form structures, there seems to be a greater acceptance of the theory that firms are profit maximisers.

As we have seen most of the short-term objectives such as sales revenue maximisation, are very important short-term objectives but tend to inevitably lead to higher profits in the long term. With multi divisional organisations it is easier for the executives to aim for profit maximisation as they entrust the day to day running to the separate departments who are responsible for the main decisions whilst being advised by the top level management.

To conclude I would accept that although business have shorter term objectives and are working within constraints which may threaten maximisation theories, it is clear that very few business would continue to operate with no profits. Firms can enjoy the incentive of higher profits if they can attract sufficient consumers to buy their products, and so I would accept that as short-term objectives those such as sales maximisation cannot be ignored.

However the traditional neo-classical approach of profit maximisation seems to be the underpinning of almost every organisation regardless of size or status. Having said that I feel that it would be unwise of businesses to completely disregard the behavioural model as its foundations are built on achieving realistic results in a firm, as so it should be seen as a useful complement to the maximisation theories rather than as a substitute for them.

References:

Harvey, J, Mastering Economics – Macmillan (2000)

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