Theory Of The FirmAre Firms Just In

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Theory Of The Firm-Are Firms Just In Business To Make Profits Essay, Research Paper 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. The most serious critique on the theory of the firm comes from those who question whether firms even make an effort to maximise their profits. A firm (especially a large corporation) is not a single decision-maker , but a collection of people within it. This implies that in order to understand the decision-making process within firms, we have to analyse who controls the firm and what

their interests are. The fact that most large companies are not run by the their owners is often brought forward to support this claim. A large corporation typically is 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. Since ownership gives a person a claim on the profit of the firm, the greater the firm’s profit, the higher the owners income. Hence the owners goal will be profit maximisation. When managers salary stays unaffected by higher profits they may pursue other goals to raise their personal

utility. This behaviour strikes the critical observer regularly when for example reading or watching the financial media. Managers there often rather mention the rises in sales or the growth of their company rather then the profits. Some economists like Begg (1996) argued that managers have an incentive to promote growth as managers of larger companies usually get higher salaries. Others like Williamson (1964) suggested that managers derive further utility from perquisites such as big offices, many subordinate workers, company cars etc. Fanning (1990) gives a rather bizarre example: When WPP Group PLC took over the J. Walter Thompson Company, they found that the firm was spending $80,000 p.a. to have a butler deliver a peeled orange every morning to one of their executives. An

unnecessary cost clearly from the perspective of the company owners. But often it becomes difficult to identify and separate this amenity maximisation from profit maximisation. A corporate jet for example could be either justified as a profit maximising response to the high opportunity cost of a top executive or an expensive and costly executive status symbol. Baumol (1967) hypothesised that managers often attach their personal prestige to the company s revenue or sales. A prestige maximising manager therefore would rather attempt to maximise the firms total revenue then their profits. Figure 1 illustrates how the output choices of revenue- and profit maximising managers differ. The figure plots the marginal revenue and marginal cost curves. Total Revenue peaks at x r , which is

the quantity at which the marginal revenue curve crosses the horizontal axis. Any quantity below x r , marginal revenue will be positive and the total revenue curve will rise as output goes up. Hence a revenue-maximising manager would continue to produce additional output regardless of its effects on cost. Given this information one might ask why the owners don t intervene when their appointed managers don t direct their actions in the interest of the owners, by maximising profits. First of all, the owners will not have the same access to information as the managers do. Where Information relates to professional skills of Business administration as well as those of the firms inner structure and its market enviroment. Furthermore, when confronted with the owners demands for profit