OBJECTIVES OF OBJECTIVES OF BUSINESS FIRMSBUSINESS FIRMS

what is an organisation?what is an organisation?

“ “An organisation is a consciously An organisation is a consciously coordinatedcoordinated social unitsocial unit composed of composed of two or more ‘people’ ,that function on two or more ‘people’ ,that function on a relatively continuous basis to a relatively continuous basis to achieve a common achieve a common goal or set of goal or set of goalsgoals.”.”

“ “ There is no reason to believe that all There is no reason to believe that all businessmen pursue the same businessmen pursue the same objective.” – Baumolobjective.” – Baumol

Profit as an objective of firmProfit as an objective of firm

““The word profit has different meaning to The word profit has different meaning to businessmen, accountants, tax collectors, businessmen, accountants, tax collectors, workers..” - Joel Deanworkers..” - Joel Dean

Accounting profit Vs Economic profit Accounting profit Vs Economic profit

Theories of profitTheories of profit

- Walker’s theory of profit – as rent of ability- Walker’s theory of profit – as rent of ability

- Clark’s dynamic theory - Clark’s dynamic theory

‘ ‘ profit is an elusive sum which profit is an elusive sum which entrepreneurs grasp but cannot hold. It entrepreneurs grasp but cannot hold. It slips through their fingers and bestows on slips through their fingers and bestows on all members of the society.’ – J.B.Clark all members of the society.’ – J.B.Clark

- Hawley’s risk theory – Residual theory of profit- Hawley’s risk theory – Residual theory of profit - Knight’s theory of profit – Risk & Uncertainty - Knight’s theory of profit – Risk & Uncertainty

(A) (A) RiskRisk:: A low probability of an expected outcome (in A low probability of an expected outcome (in common)common)

From business decision making point of view, risk From business decision making point of view, risk refers to a situation in which a business decision is refers to a situation in which a business decision is expected to yield more than one outcome and the expected to yield more than one outcome and the probability of each outcome is known to the decision probability of each outcome is known to the decision maker and can be reliably estimated.maker and can be reliably estimated.

(B) (B) UncertaintyUncertainty: It refers to a situation in which there are : It refers to a situation in which there are more than one outcome of a business decision and the more than one outcome of a business decision and the probability of no outcome is known or can be probability of no outcome is known or can be meaningfully estimated.meaningfully estimated.

Due to – Lack of Reliable market informationDue to – Lack of Reliable market information - Inadequate past experience- Inadequate past experience - High volatility of market conditions - High volatility of market conditions

- Schumpeter’s innovation theory of profit- Schumpeter’s innovation theory of profit

- Monopoly profit- Monopoly profit

Problems in profit measurementProblems in profit measurement

- Which profit concept to be used?- Which profit concept to be used?

- What costs should be & what costs should not be - What costs should be & what costs should not be included? included?

> Depreciation> Depreciation

> Capital gains & losses> Capital gains & losses

> Current Vs Historical costs – Assets; specially > Current Vs Historical costs – Assets; specially inventory –inventory –

FIFO, LIFO & WAC FIFO, LIFO & WAC

Profit Maximisation as an objective of firmProfit Maximisation as an objective of firm- It has never been unambiguously It has never been unambiguously

disapproved. disapproved. - No alternative hypothesis explains & No alternative hypothesis explains &

predicts the behaviour of the firms better predicts the behaviour of the firms better than this theory.than this theory.

Conditions for maximising profitConditions for maximising profit

- - Necessary / first order condition:Necessary / first order condition: MR = MR = MCMC

-- Secondary / second order condition: Secondary / second order condition: The necessary condition must be satisfied The necessary condition must be satisfied under the condition of decreasing MR & under the condition of decreasing MR & rising MCrising MC

The defence of profit maximisation:The defence of profit maximisation:

- - Profit is indispensable for firm’s survivalProfit is indispensable for firm’s survival

- - Other objectives’ success is dependent on Other objectives’ success is dependent on firm’s firm’s

ability to make profit ability to make profit

- It has got a great predictive power- It has got a great predictive power

- Profit is a more reliable measure of firm’s- Profit is a more reliable measure of firm’s

efficiency efficiency

- Evidence against this objective are not - Evidence against this objective are not conclusiveconclusive

( Hall & Hitch survey) ( Hall & Hitch survey)

- Purpose of traditional theory of value is - Purpose of traditional theory of value is different different

(Fritz Maclup’s observation) (Fritz Maclup’s observation)

Controversy over profit Controversy over profit maximisation:maximisation:

- Separation of ownership & management- Separation of ownership & management

- Assumption of full knowledge of the - Assumption of full knowledge of the marketmarket

conditions on the part of firm is conditions on the part of firm is questionable. questionable.

- Marginality principle is not widely in use.- Marginality principle is not widely in use.

Alternative objectives of firmsAlternative objectives of firms

B-G-M HypothesisB-G-M Hypothesis

- Owner controlled firms have higher - Owner controlled firms have higher profit ratesprofit rates

than the manager controlled firms.than the manager controlled firms.

- The managers have no incentives - The managers have no incentives for profitfor profit

maximisation.maximisation.

Baumol’s Hypothesis of sales revenue Baumol’s Hypothesis of sales revenue maximisationmaximisation Managers pursue those goals which furthers Managers pursue those goals which furthers

their interest.their interest. - Salary & other management emoluments - Salary & other management emoluments

are more closely related to sales revenue are more closely related to sales revenue than to profit.than to profit.

- Banks & other financial institutions look at - Banks & other financial institutions look at sales revenue for credibility.sales revenue for credibility.

- Sales revenue trend is more readily - Sales revenue trend is more readily available indicator of the firm’s performanceavailable indicator of the firm’s performance

- Managers find it difficult to maximise the - Managers find it difficult to maximise the profit consistently due to changing & profit consistently due to changing & challenging conditions.challenging conditions.

- - Static & Dynamic modelStatic & Dynamic model

Marris’s Hypothesis of firm’s growth rate Marris’s Hypothesis of firm’s growth rate maximisationmaximisation““Managers try to maximise firm’s Managers try to maximise firm’s balanced growthbalanced growth rate rate subject to managerial & financial subject to managerial & financial

constraints.”-constraints.”- Robin MarrisRobin Marris

G = GG = GDD = G = GCC

GGD D = Growth rate of demand for firm’s product= Growth rate of demand for firm’s product

GGCC= Growth rate of capital supply to the firm= Growth rate of capital supply to the firm Um = f (salary, power, job security, prestige, Um = f (salary, power, job security, prestige,

status..)status..) Uo = f (output, capital, market share, profit, Uo = f (output, capital, market share, profit,

publicpublic esteem..) esteem..) ‘ ‘ Size of the firm’ Size of the firm’

Williamson's Hypothesis of Williamson's Hypothesis of maximisation of managerial utilitymaximisation of managerial utility

‘ ‘ Managers seek to maximise their own Managers seek to maximise their own utility function.’utility function.’

U = f (S, M, IU = f (S, M, ID D ))

S = Additional expenditure on staffS = Additional expenditure on staff

M = Managerial EmolumentsM = Managerial Emoluments

IID D = Discretionary investment= Discretionary investment

Cyert - March Hypothesis of Cyert - March Hypothesis of satisficing behaviour (Simon’s satisficing behaviour (Simon’s Hypothesis)Hypothesis)

‘ ‘ A firm is a coalition of different groups A firm is a coalition of different groups with conflicting goals.’ – with conflicting goals.’ – Aspiration level of Aspiration level of the firmthe firm

Rothschild’s Hypothesis of long run Rothschild’s Hypothesis of long run survival & market share goalssurvival & market share goals

‘ ‘ The primary goal of a firm is long run The primary goal of a firm is long run survival.’ survival.’

Entry prevention & Risk avoidance Entry prevention & Risk avoidance Hypothesis Hypothesis

Motive Motive : : a) profit maximisation in the long a) profit maximisation in the long runrun

b) Securing a constant market shareb) Securing a constant market share

c) Avoiding the risk caused by the c) Avoiding the risk caused by the

unpredictable behaviour of new unpredictable behaviour of new firms firms

A reasonable profit targetA reasonable profit target

Why reasonable profit?Why reasonable profit?

a) Preventing entry of new firmsa) Preventing entry of new firms

b) Projecting a favourable public b) Projecting a favourable public imageimage

c) Restraining trade union demandsc) Restraining trade union demands

d) Maintaining customer goodwilld) Maintaining customer goodwill

e) Managerial utility function is e) Managerial utility function is more preferablemore preferable

to profit maximisation etc.to profit maximisation etc.

Standards of reasonable profit Standards of reasonable profit

- - Forms of profit standardsForms of profit standards

a) Aggregate money termsa) Aggregate money terms

b) Percentage of salesb) Percentage of sales

c) Percentage of ROIc) Percentage of ROI

- How much profit is reasonable? - - How much profit is reasonable? - StandardsStandards

a) Capital attracting standarda) Capital attracting standard

b) ‘ Plough back’ standardb) ‘ Plough back’ standard

c) Normal earning standards c) Normal earning standards