Objectives of the Firm Essay

The standard economic assumption underlying the analysis of levels is turn a avail maximization. Real world levels, however, capability not, and many an(prenominal) times do not, pass water decisions based on the profit-maximization object lens, or at least exclusively on the profit-maximization objective. Other objectives include (1) gross revenue maximization, (2) pursuit of person-to-person welf ar, and (3) pursuit of loving welf ar. Although firms be assumed to agree decisions that increase profit in standard economic analysis, real world firms often pursue other objectives on a day-after-day basis.Some firms set their sights on maximising sales. For other firms the owners or employees are inclined to enhance personal living standards. And to a greater extent than a few firms stimulate steps that promote the ov date of referencell welfare of society. In some cases, these other objectives help a firm pursue profit maximization. In other cases, they block a firm fro m maximizing profit. emolument Maximization Profit maximization is the process of obtaining the highest possible take aim of profit through the production and sale of goods and services.This is the directing principle underlying the analysis of short-run production by a firm. In particular, economic analysis is assumed that firms undertake actions and make the decisions that increase profit. Profit is the difference among the total revenue a firm receives from failing output and the total cost of producing that output. Profit-maximization means that a firm seeks the production level that generates the greatest difference between total revenue and total cost. Consider how profit maximization might work for The Wacky Willy community.Suppose that The Wacky Willy come with generates $100,000 of profit by producing 100,000 Stuffed Amigos, the difference between $1,000,000 of revenue and $900,000 of cost. * If profit falls from this $100,000 level when The Wacky Willy Company brea ks more (100,001) or fewer (99,999) Stuffed Amigos, then it is maximizing profit at 100,000. Alternatively, if profit can be increased by producing more or less, then The Wacky Willy Company is NOT maximizing profit at the current level of production. Suppose, for example, that producing 100,001 Stuffed Amigos adds an extra $11 to revenue but only $9 to cost.In this case, profit can be increased by $2, reaching $100,002, by producing genius more Stuffed Amigo. As such 100,000 is NOT the profit maximizing level of production. * In contrast, suppose that producing 99,999 Stuffed Amigos reduces cost by $11 but only reduces revenue by only $9. In this case, profit can too be increased by $2, reaching $100,002, by producing one fewer Stuffed Amigo. As such 100,000 is NOT the profit maximizing level of production.Sales Maximization A reasonable, and often pursued objective of firms is to increase sales, that is, to sell as much output as possible. Clearly sales lead to revenue, meaning that maximizing sales is also bound to maximize revenue. But as the analysis of short-run production indicates, maximizing sales does NOT necessarily maximize profit. So why do firms do it? be firms unreasonable? Are they irrational? Do they NOT understand the basic economic principles of short-run production? For some firms, the answers to these questions could be yes.But for other firms, sales maximization is truly a reasonable, even better, alternative to profit maximization. Consider, the day-to-day production of Wacky Willy Stuffed Amigos. Suppose the President of The Wacky Willy Company, William J. Wackowski, issues a corporate directive to sell as many Stuffed Amigos as possible, to maximize sales. Is Willy Wackowski wacky? It might be that Mr. Wackowski has no knowledge of basic economic principles. Alternatively Wacky William might have more business sense than it appears.In particular, if the price received from selling Stuffed Amigos is greater than the cost of produci ng each one, and looks to remain that way regardless of the quantity promoted, then a reasonable address is to maximize sales. If sales are greater, then so too is profit. Wacky Willy does NOT maximize profit under these circumstances. That is, it does not get down the quantity that achieves the highest possible profit. However, with each Stuffed Amigo produced, profit increases. In fact, Wacky Willy might not KNOW the profit-maximizing production level.All it knows is that selling more Stuffed Amigos, increases profit. while sales maximization can serve as a means of pursing profit maximization, it can also baffle a firm from maximizing profit. The reason, of course, is that if sales become so prominent that the cost of production increases such that marginal cost exceeds marginal revenue, the maximizing sales does not maximize profit. Pursuit of person-to-person Welfare The people who make decisions for a business are, in fact, people. They have likes and dislikes. They hav e personal ends and aspirations just like people who do not make decisions for firms.On occasion these people use the firm to pursue their own personal welfare. When they do, their actions could enhance the firms profit maximization or, in many cases, prevent profit maximization. How about a few examples? Once again, consider William J. Wackowski, the president of The Wacky Willy Company. Perhaps Willy enjoys the finer things in lifea large house, fancy cars, and expensive vacationswhich require a hefty income. As the primary stockholder of The Wacky Willy Company, when the business maximizes profit, then William J. Wackowski benefits with more income.In this case, the pursuit of personal welfare coincides with profit maximization. Alternatively, suppose that the Mr. Wackowski hates the color empurple. He simply refuse to produce ANY purple Stuffed Amigos. However, market studies clearly indicate that buyers want purple Stuffed Amigos. Moreover, the purple fabric that would be use d to produce purple Stuffed Amigos is significantly less expensive than other colors. Mr. Willy clearly is wacky in this case. His purple-phobia prevents profit maximization. William the Wackster might also decide to enhance his corporate lifestyle at the expense of corporate profit.He could, for example, give himself a bigger, more luxurious (but unneeded) office, a higher(prenominal) (but unneeded) salary, a ships family jet (also unneeded), season tickets to Shady Valley Primadonnas baseball team (clearly unneeded) and other (unneeded) amenities that are NOT needed to profitably produce Stuffed Amigos. These improve Williams personal welfare, but at the expense of corporate profit. Pursuit of Social Welfare The people who make decisions for firms also have affable consciences. Part of their likes and dislikes might be related to the overall state of society.As such, they might use the firm to pursue cordial welfare, which could enhance or prevent the firms profit maximizatio n. How might William J. Wackowskis pursuit of social welfare enhance or prevent profit maximization of The Wacky Willy Company? Suppose that William wants a discaseer environment. As such, he might implement more costly environmentally friendly production techniques and materials. He does his part to clean the environment, but at the expense of company profit. Then again, Mr. Wackowski might feel that government environmental quality regulations restrict peachy investment and economic growth.As such, William might have The Wacky Willy Company use part of its advertising budget to promote this view point. He might even use company revenue to set up the Wackowski Foundation for Policy Studies that is both a scientific think tank and a special interest lobbying organization with the conclusion of reducing environmental quality regulations. While the pursuit of social welfare is liable(predicate) to reduce company profit, it could have the opposite effect as well. such(prenominal) a ctivities could give The Wacky Willy Company a likeable public image that motivates people to buy more Stuffed Amigos than they would otherwise.In fact, some firms use the pursuit of social welfare as one aspect of their overall advertising efforts. They enhance their public image at the same time they do something good for society. lifelike Selection Whichever objective a firm pursues on a day-to-day basis, the notion of inwrought selection suggests that successful firms intentionally or unintentionally maximize profit. That is, the firms silk hat suited to the economic environment, and thus generate the more or less profit, are the ones that tend to survive.The natural selection of business firms is an adaptation of the biological process of natural selection, in which biological entities best suited to the natural environment are the ones that survive. The concept of economic natural selection means that those firms that generate the greatest profit are the ones that avoid ba nkruptcy and survive to produce another day. While firms might pursue sales maximization, personal welfare, or social welfare, only those firms that also maximize profit remain in business. 2) The following is from chapter one in the text Financial Management and Policy, by James C.Van Horne, Copyright 1974 by Prentice-Hall. It is classic finance. THE OBJECTIVE OF THE FIRM In this course, we assume that the objective of the firm is to maximize its value to its stockholders. Value is represented by the market price of the companys common stock, which, in turn, is a reflection of the firms investment, financing, and dividend decisions. Profit Maximization vs. Wealth Maximization Frequently, maximization of wage is regarded as the decent objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealth.For one thing, total profits are not as important as fee per share. A firm could always raise total profits by issuing stock and using the growth to i nvest in Treasury bills. Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of evaluate returns. Is the investment project that result produce $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years?An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few quick stockholders would think favorably of a project that promised its first return in 100 years. We must take into account the time pattern of returns in our analysis. some other shortcoming of the objective of maximizing earnings per share is that it does not consider the danger or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken .In addition, a company will be more or less risky depending upon the amount of debt in relation to equity in its capital structure. This risk is known as financial risk and it, too, contributes to the uncertainty of the prospective stream of earnings per share. Two companies may have the same anticipate future earnings per share, but if the earnings stream of one is subject to considerably more uncertainty than the earnings stream of the other, the market price per share of its stock may be less. For the reasons above, an objective of maximizing earnings per share may not be the same as maximizing market price per share.The market price of a firms stock represents the focal judgment of all market participants as to what the value is of the particular firm. It takes into account present and prospective future earnings per share, the timing, duration, and risk of these earnings, and any other factors that bear upon the market price of stock. The market price serves as a performance index or report card of the firms progress it indicates how well commission is doing in behalf of its stockholders. Management vs. Stockholders In certain situations the objectives of management may differ from those of the firms stockholders.In a large skunk whose stock is widely held, stockholders exert very little control or influence over the operations of the company. When the control of a company is separate from its ownership, management may not always act in the best interests of the stockholders Agency Theory. Managers sometimes are said to be satisficers rather than maximizers they may be content to command it safe and seek an acceptable level of growth, being more concerned with perpetuating their own existence than with maximizing the value of the firm to its shareholders.The most important goal to a management teamof this sort may be its own survival. As a result, it may be unwilling to take reasonable risks for fear of qualification a mistake, thereby becoming cons picuous to the outside suppliers of capital. In turn, these suppliers may pose a threat to managements survival. It is true that in articulate to survive over the long run, management may have to behave in a manner that is reasonably consistent with maximizing shareholder wealth. Nevertheless, the goals of the dickens parties do not necessarily have to be the same. Maximization of shareholder wealth, then, is an appropriate slip by for how a firm should act.When management does not act in a manner consistent with this objective, we must recognize this as a constraint and determine the opportunity cost. This cost is measurable only if we determine what the takings would have been had the firm attempted to maximize shareholder wealth. A Normative Goal Because the principal of maximization of shareholder wealth provides a rational guide for running a business and for the efficient allocation of resources in society, we use it as our assumed objective in considering how financial de cisions should be made.The purpose of capital markets is to efficiently allocate savings in an economy from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be channeled to the most promising investment opportunities, a rational economic criteria must exist that governs their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. The market value of a firms stock embodies both of these factors. It therefore reflects the markets tradeoff between risk and return.If decisions are made in keeping with the likely effect upon the market value of its stock, a firm will attract capital only when its investment opportunities give up the use of that capital in the overall economy. Put another way, the equilibration process by which savings are allocated in an economy occurs on the basis of expected return and risk. Holding risk constant, those economic units (business firms, households, financial ins titutions, or governments) willing to pay the highest yield are the ones entitled to the use of funds.If rationality prevails, the economic units process the highest yields will be the ones with the most promising investment opportunities. As a result, savings will tend to be allocated to the most efficient users. Maximization of shareholder wealth then embodies the risk-return tradeoff of the market and is the focal point by which funds should be allocated within and among business firms. Any other objective is likely to result in the suboptimal allocation of funds and therefore lead to less than optimal level of economic want satisfaction. This is not to say that management should miss the question of social indebtedness.As related to business firms, social responsibility concerns such things as protecting the consumer, paying fair wages to employees, maintaining fair hiring practices, reenforcement education, and becoming actively involved in environmental issues like clean a ir and water. Many people feel that a firm has no pickax but to act in socially responsible ways they argue that shareholder wealth and, perhaps, the corporations vary existence depends upon its being socially responsible. However, the criteria for social responsibility are not clearly defined, making formulation of a consistent objective function difficult.Moreover, social responsibility creates certain problems for the firm. One is that it falls jaggedly on different corporations. Another is that it sometimes conflicts with the objective of wealth maximization. Certain social actions, from a long-range point of view, unmistakably are in the best interests of stockholders, and there is little question that they should be undertaken. Other actions are less clear, and to engage in them may result in a decline of profits and in shareholder wealth in the long run. From the standpoint of society, this decline may produce a conflict.What is gained in having a socially desirable goal ac hieved may be offset in whole or part by an accompanying less efficient allocation of resources in society. The latter will result in a less than optimal growth of the economy and a lower total level of economic want satisfaction. In an era of unfilled wants and scarcity, the allocation process is extremely important. Many people feel that management should not be called upon to resolve the conflict posed above. Rather, society, with its broad full general perspective, should make the decisions necessary in this area.Only society, acting through Congress and other representative governmental bodies, can judge the relative tradeoff between the achievement of a social goal and the sacrifice in the efficiency of apportioning resources that may accompany realization of the goal. With these decisions made, corporations can engage in wealth maximization and thereby efficiently allocate resources, subject, of course, to certain governmental constraints. Under such a system, corporations c an be viewed as producing both private and social goods, and the maximization of shareholder wealth remains a viable corporate objective.