Business Economics Theory of FirmFirm Behaviour Profit Maximisation

Business Economics Theory of Firm/Firm Behaviour Profit Maximisation 12 March 2021

Business Aims and Objectives n An aim or objective is a statement of what a business is trying to achieve. For example, a business can set itself any of these targets: survival profit maximisation growth provide a service social responsibility n A new cafe may just aim to survive its first year n n n

Theory of Firms – Behaviour and Objectives of firms: n n n n Profit maximisation Profit satisficing Long term survival Share price maximisation Revenue maximisation Brand loyalty Expansion and market dominance Non-profit maximisation strategies and behaviour

Profit Economist – it means the difference between total cost and total revenue (Total Profit = TR-TC) Entrepreneur – profit is an incentive to undertake risk in the belief that a gain can be made. Profit is the reward that encourages them to take risks (Firms can also make losses)

Profit n Profit is calculated by subtracting the total costs (TC) of production from the total revenue (TR) of selling the product. PROFIT = TOTAL REVENUE(TR) – TOTAL COST (TC)

Functions/Role of Profit n Measure of how the Business is Performing n Premium to cover costs of staying in business n Ensuring supply of future Capital n Meet the needs of the main ‘stakeholders’ n Gives added value n Drives the business

Role of profit: Adding Value Difference between the input costs (raw materials, etc. ) and the value placed on the product/service by the market n Value added may be tangible – additional features or intangible – brand image, style, etc. n Value Chain – value adding activities in a product or service n

The role of profit n Profit as a reward for the entrepreneur n Profit as an incentive to produce n Profit a signal for the entrepreneur to enter the market

Profit Functions of Profit n Existence of profit suggests: - Demand buoyant, prices may be rising, worth entering market Profit attracts new businesses n Profit encourages efficiency n Profit encourages enterprise, innovation and risk taking n

Reasons for Aiming at reasonable profit n Preventing entry of competitors n Projecting a favourable public image (Brand Image) n Restraining trade union demand n Maintaining customer good will n Being an employer of choice

Profit Maximisation Based on two premises: - 1. That owners are in control of the day-to-day management of the firm 2. The main desire of owners is for higher profit.

Role of Profit - Drives Business Objectives n Normal profit – the minimum amount needed to keep a business in a particular line of production (TR=TC). At his point also AR =AC which means the firm is at Break-even point. n Supernormal Profit – any profit over and above normal profit – where TR is greater than Total Cost – (Abnormal profit – profit above normal profit – market power? ) n Subnormal profit – below normal profit – how long can the firm survive?

Profit maximisation n Profit maximisation occurs where: Marginal Revenue (MR) = Marginal Cost (MC) (where the revenue raised from selling an extra unit is equal to the cost of producing that extra unit) The point at which MCs and MRs are equal is the point at which profits are maximised.

Profit Maximisation Economic theory presumes that all entrepreneurs and firms are motivated to maximise their Profits; Where Marginal Cost (MC) = Marginal Revenue (MR) This can measure how successful the entrepreneur has been

Profit Maximisation Source: Econ Web

Profit Maximisation Firms try to ensure that the revenue obtained from the sale of products/services exceeds the costs incurred in supplying those goods/services. Cost Reduction Firms constantly search for ways of reducing the costs of producing their current output. • Finding cheaper courses of inputs • Taking advantage of new technology • More efficient machinery/IT • Learning by experience of how to utilise their existing resources more efficiently • Networking • Redesigning product using cheaper material

Losses When costs exceed revenue over a period - Caused by temporary downturn in economy - Caused by external shocks - Caused by changing tastes/fashions/technology n Necessity of covering variable costs n Losses can be sustained: - Restructuring Re-financing – shares/loans Using reserves Cut costs Boost sales

Increase profit - Strategy Reduce costs n Increase price n Ensure revenue is always greater than cost and is in profitmaking situation. n However making constant changes to prices and costs creates instability and organisations will try to take a more strategic or long-run view n A firm will try alternative strategy to profit maximisation

Business Economics Alternatives to Profit Maximisation 12 March 2021

Non-maximising behaviour – Management for Value –Example Plc n n n n Increase earnings per share by at least 10% Generate £ 150 million of free cash flow every year Doubling the value of shareholders’ investment in the four years to 2011 Competing in the world’s growth market by effective internal investment and by value-enhancing acquisitions Developing market share by introducing innovations in product development, packaging and routes to market Increasing commitment to value creation in managers and employees through incentive schemes and share ownership Investing in key areas of air emissions, water, energy and solid waste

Business Ethics and Corporate Social Responsibility? Business Ethics Addresses how to manage Business relationships to Its immediate stakeholders (employees, customers, Shareholders, suppliers etc. Historical roots in law Moral Values Professional Codes CSR Addresses how to manage the Business relationships to its stakeholders and the local and international communities & environment Historical roots in corporate citizenship Globalisation/World Trade

Milton Friedman and CSR n Milton Freidman’s article – he had a number of criticisms – mainly “A Firms primary responsibility is to ‘Shareholders’ not to ‘Stakeholders’ or society. No responsibility other than maximising profits”

Wealth Maximisation Model The theory of corporate finance suggests an alternative financial objective to profit maximisation that can provide a day-to-day focus for management. This theory assumes that management’s main job is to maximise the value or wealth of the business. Within this context, management seek to ensure that investments made by the business earn a return that is satisfactory to shareholders.

Principle- Agent Problem Dominant form of industry – Public Ltd Company (Plc)/ Public Sector run by managers rather than owners. Leads to conflict between owners (shareholders) and Managers (agents): a) Agents may not always act in the manner desired by shareholders b) Independence of action due to managers superior knowledge of company c) Acting on different agenda – aims and objectives

Stakeholder Theory Stakeholder Engagement Democratic form of corporate accountability 12 March 2021

Competitors Government Customers Shareholders Suppliers Firm Employees Civil Society

Class Activity n Discuss the different interests of each of the stakeholders and what the firm would do to try and meet their interests.

Stakeholder Theory COMPANY’S INFLUENCE Low Stakeholder’s interest High Minimal Effort Low priority for attention Medium Priority for attention Keep Satisfied Keep Inform Medium priority for attention High Priority for attention Crucial Key Players How stakeholders’ influence and interests affect corporate prioritization Source: Blowfield and Murray (2011)

Corporate Social Responsibility (CSR_) CSR generally refers to the concept that business has a responsibility to society that extends beyond the primary stakeholders. (sage, 2012) n Griseri and Seppala (2010) go further and argue that CSR refers to behaviour beyond the legal and economic requirements and includes the acceptance of additional responsibilities n Carroll (1991) focuses on the expectations placed on organisations and proposed a four part model n

Approach to CSR (CIPD 2012) n n n Environment – from recycling materials to the whole carbon footprint of the organisation Marketplace – including issues such as fair trading and corporate taxes Workplace – focusing on the rights and well-being of employees Community – for example, supporting local community projects financially or via employee volunteering programmes Global – workplace issues might include child labour and human rights with global value chain.

Carroll’s four-part model of corporate social responsibility CSR (Carroll, 2004, 1991, C&M) Desired by society Philanthropic Responsibilities Ethical Responsibilities Expected by society Required by society Legal Responsibilities Required by society Economic Responsibilities Source: Carroll (1991)

Carroll’s Model of CSR n Economic Responsibilities – the primary responsibility of a company is to produce goods and services at a profit and contribute to economic development n Legal Responsibilities – Companies are also expected to act within a legal framework. Laws reflect society’s values and norms

Carroll’s Model of CSR Ethical Responsibilities – Business should conform to the ethical norms of society. Carroll argues these are ambiguous and can be difficult. Ethical concerns often predict new laws and regulations e. g. women’s rights, health and safety, consumer rights, age concern etc. n Philanthropic responsibilities – Business engage in activities beyond normal expectations. This includes voluntary work, charitable donations and sponsor-ship particularly sorts and local communities. n

What is organizational social responsibility? Ø Arguments against social responsibility: - Reduced business profits Higher business costs Dilution of business purpose Too much social power for business - Lack of public accountability 34 Ø Arguments in favor of social responsibility: - Adds long-run profits - Better public image - Avoids more government regulation - Businesses have resources and ethical obligation - Better environment - Public wants it

Alternatives to Profit Maximisation n n n n Satisficing behaviour (Simon 1959) Social Responsibility Individual motives Sales Revenue maximisation theory (Professor W J Baumol 1967) Growth maximisation theory (Professor Robin Marris 1964) Cost-plus pricing method – type of oligopoly behaviour (Hall and Hitch 1930) Management Discretion Model (Williamson) Williamsons theory

End Class 12 March 2021

Business Economics Alternatives to Profit Maximisation Monday Class – Profit Max/Supply (You tube) 12 March 2021 Revision

Profit maximisation n Profit maximisation occurs where: Marginal Revenue (MR) = Marginal Cost (MC) (where the revenue raised from selling an extra unit is equal to the cost of producing that extra unit) The point at which MCs and MRs are equal is the point at which profits are maximised.

Profit Maximisation Source: Econ Web

Alternatives to Profit Maximisation n n n n Satisficing behaviour (Simon 1959) Corporate Social Responsibility (Carroll 2004) Individual motives Sales Revenue maximisation theory (Professor W J Baumol 1967) Growth maximisation theory (Professor Robin Marris 1964) Cost-plus pricing method – type of oligopoly behaviour (Hall and Hitch 1930) Management Discretion Model (Williamson) Williamsons theory

Pricing Strategy – Cost-Plus Pricing (Hall & Hitch 1930) A business can make a profit only if the price charged eventually covers the cost of making the item. n One way to ensure profit is to use cost-plus pricing strategy to make a profit. n n Drawback may not be competitive n (Other pricing strategies – Sometimes lower price below cost -Loss Leader strategy to gain sales and market share

Sales Revenue Maximisation Model (Baumol 1959) This model argues that businesses try to maximise sales or revenues rather than profits. There are several possible motives for such an objective: • Grow or sustain market share • Ensure survival • Discourage competitors (particularly new entrants to a market) • Build the prestige of the senior management – who like to be seen running a large rather than a particularly profitable business • Achieve bonuses – if these are based on revenues rather than profits

Consensus/Coalition Model (Cyert & March 1963) The consensus model presents a slightly more complicated model of business objectives. In this case, it is argued that a business is an organisational coalition of shareholders, managers, employees and customers – each with different objectives. Management therefore try to reach a consensus with these different groups – each of which must settle for less than they would otherwise want. Shareholders, therefore have to settle for profits that are less than theoretical maximum, perhaps to ensure that employees do better.

Growth of Sales Revenue - Sales revenue maximisation Williamson (1963) Growth of sales revenue as a major firm objective. Managers seek to increase satisfaction through the greater expenditure on both staff levels and projects made possible by higher sales revenue. Funds for expenditure come from profits, external finance and sales revenue.

Constrained sales revenue maximization (Baumol & Williamson) Maximum sales revenue is usually considered to occur well above the level of output which generates maximum profits. The shareholders may demand at least a certain level of distributed profit, so that sales revenue can only be Maximised subject to this constraint.

Non- Maximising Goals – Behaviourist Theorist View Managerial Discretion Models Managers often have discretionary powers in deciding on price and output and marketing in different segments of markets n Much depends on the degree of autonomy that the head office of a business gives to its managers n Maximising behaviour may be replaced by satisficing ie setting minimum acceptable levels of achivement

Satisficing - Simon (1959) Satisficing = Satisfy + Suffice Suggests that in practice managers are unable to ascertain when a marginal point has been reached ie maximum profit with marginal cost equal to marginal revenue. Management by objectives – means of setting objectives as an incentive to improving performance

Management Discretion Model (Williamson) In this model, Williamson argues that management act to further their own interests – in other words to achieve personal utility rather than to meet the interests of outside investors. Businesses run with this kind of objectives tend to deliver high levels of remuneration to management rather than the highest possible profits.

Non-Maximising behaviour n Portfolio planning – evidence of ever-changing objectives guiding the firm activity rather than any single objective. (Boston Consulting Group - Boston Box)

Williamson – winner of Nobel Prize 2009 – Economics (Economic Governance n Economists need to do more than study markets and prices n Williamson theory – vertical integration

Law of Diminishing Returns n The Law of Diminishing Returns refers to the short run production function – where there is at least one fixed factor input. n See Handout

The law of diminishing marginal returns If a firm increases output by adding variable labour to fixed capital then eventually diminishing marginal returns (physical product of labour) will set in. n In other words, at some point an extra worker will add less output to the grand total than the previous worker. n

Elinor Ostrom (2009) Nobel prize winner 2009 n Local decision making can lessen tragedy – people who use resources often develop ways to share them e. g. forest management

Profit and Loss Account – Company X for year ended 31 st December 2008 Expenditure INCOME ________________________ Variable costs Wages Materials Other Total VC £ 200, 000 300, 000 100, 000 £ 600, 000 Revenue from Sales £ 1, 000 Fixed Costs Rent 50, 000 Managerial Salaries 60, 000 Interest on Loans 90, 000 Depreciation allow 50, 000 Total FC £ 250, 000 Total Costs PROFIT £ 850, 000 £ 150, 000

Optimum output n Optimum output occurs where average total cost is at its lowest.

Profit maximising output level Profit Maximisation Output = Marginal Revenue = Marginal Cost

Carroll’s four-part model of Corporate Social Responsibility CSR (Carroll, 2004, 1991, C&M) Desired by society Philanthropic Responsibilities Ethical Responsibilities Expected by society Required by society Legal Responsibilities Required by society Economic Responsibilities Source: Carroll (1991)

Economist’s definition of profit excludes the ‘opportunity cost’ of capital - Pure Profit Example: Profit as reported by the Firm (accounts) £ 150, 000 Opportunity cost of capital Pure return on the firm’s capital Risk premium -100, 00 -40, 000 Pure or Economic Profit £ 10, 000