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A firm's main objective should be to make decisions that maximize the value of
the company for its owners, and as the owners of a company are its
shareholders, the main financial objective should be 'the maximization of
shareholder wealth'.
Since shareholders receive their wealth through dividends and capital gains,
shareholder wealth will be maximized by maximizing the value of dividends and
capital gains that shareholders receive over time.
A second problem concerns the timescale over which the profit should be
maximized.
Should profit be maximized in the short term or the long term?? Given that profit
considers one year at a time, the focus is likely to be on short-term profit
maximization at the expense of long-term investment, putting the long term
survival of the company into doubt.
There are many examples of companies going into liquidation shortly after
declaring high profits. Check out - Polly Peck Plc's dramatic failure in 1990! (good
example)
The third problem is that profit does not take account of or make any allowance
for risk! It would be inappropriate to concentrate efforts on maximizing
accounting profit when this objective does not consider one of the key
determinants of shareholder wealth.
Thoeries underlying the Objective of a Firm, mainly talk about the subject of
Ethics in Business.
Debate is going on since a long time, as to whether every Firm's Objective needs
to be ETHICAL?
the answer may seem as simple as "YES", but the counter arguements that
follow are difficult to answer.
We will assume that the overriding goal of the managers of firms is to maximize
profit: P = TR - TC. The managers do this by increasing total revenue (TR) or
reducing total opportunity cost (TC) so that the difference rises to a maximum.
An Example
Suppose you are running a business that produces and sells office furniture. It's a
small operation, and in a typical day you produce three custom desks. You are
able sell these desks for $500 apiece. You employ five workers, each of whom
earns $15 per hour ($120 per day), and you work alongside them and pay
yourself at the same rate. Material inputs cost $150 per desk. Of course, you
have additional "overhead" expenses, including rent, a secretary/bookkeeper,
electricity, etc. This overhead, which we will assume does not vary with the
number of desks produced (i.e., it's a fixed cost) comes to $130 per day. Thus,
your company earns a profit of P = ($500 x 3) - ($720 + 450 + 130) = $1500 -
$1300 = $200 per day. (Wages for six workers come to $720. Materials for three
desks cost $450. Overhead is $130.) Working five days a week for 50 weeks a
year, that comes to an annual profit of $50,000. Pretty nice - but could you do
better?
Suppose you decide to increase production to four desks per day. This requires
you to hire two more workers (at another $240) and purchase another $150
worth of materials. Overhead expense doesn't change. Your total cost rises to
$1690. You find that you are able to sell the fourth desk for $500. Was this a
good decision? [Engage brain here.]
You're right. [I'm giving you the benefit of the doubt here.] Total revenue rises to
$2000 per day, while total costs rise to $1690. Profit increases to $310 per day.
Good show, old man/woman/[insert desired politically correct term here]!
This nice result may lead you to increase production to five desks a day. If you
are able to sell all five desks for $500 each, and if your variable costs of
producing the desks - what you pay in labor and materials - doesn't increase,
producing a fifth desk makes sense. TR rises to $2500, TC rises to $2080, and
profit increases to $420. So you sell five desks.
Suppose, however, that you find that the labor market is so tight that you cannot
hire another two workers at $15 per hour. In fact, to hire your ninth and tenth
workers, you must pay $20 per hour. That increases the labor cost of the fifth
desk by $80 ($40 per worker times two workers). TC rises to $2160, which still
allows profit to increase to $340. But we have a problem brewing. Can you really
get away with paying your veteran workers $15 an hour, while at the same time
hiring new workers at $20 per hour? Not likely. So when you hire the ninth and
tenth workers, you are forced to raise the wages of your first eight workers (Pay
yourself more; hey, you deserve it.). Let's recalculate profit for Q = 5. TR = $500
x 5 = $2500. TC = ($160 x 10) + ($150 x 5) + $130 = $2480. That leaves a
profit of $20. Doesn't look like such a good idea now, does it Einstein? Thus, if
you realize that your costs will rise sharply if you produce a fifth desk each day,
you will decline to produce the desk.
Application
Our little example illustrates the situation every business owner or manager
faces. Businesspeople know what their current position is (revenue and costs)
and they can estimate TR and TC for a higher (or lower) level of production. By
actually changing output levels, they learn by experience what their demand and
cost curves look like. In the process, they discover what happens to profit as they
change output levels. Through this discovery process, businesspeople seek to
find the output level that maximizes profit.
The profit-maximization rule applies both to firms that are able to sell their
product at a constant price (as in our example) and to firms that find they must
reduce the price of their product to increase sales. In the real world, firms have
to engage in trial-and-error discovery processes, searching for the profit-
maximization point. But the process can be succinctly described by the marginal
revenue-marginal cost rule.