Profit Maximisation and Shareholders

Keywords: shareholder earnings, short-term profit

Profit is obtained by subtracting total cost (TC) from total revenue. Beneath the assumption of the neoclassical theory, a firm will try to produce a level of output where the difference between your total revenue and total cost is the foremost as mentioned by Holcombe (2009) whom supported Pindyck and Rubinfeld's explanation. "The maximisation of TR-TC is the equilibrium condition for a profit-maximising organization" (Powell, 2009). This is because once the firm gets the most profit from a particular degree of productivity and sales, it will not be incentivised to alter the level of result that is providing it the most yields in total investment performance.

A company which strictly employs the principal assumption of the neoclassical theory of the company can make its decisions on inputs and outputs predicated on the marginal ramifications of the components in the income equation. In doing so leading economists to arrive at the conclusion that the problem for earnings maximisation to be achieved is when marginal revenue and marginal cost are similar, in other words, total profit grows to its maximum point where MC and MR intersect. This is also known as the next order condition. Perloff says, "To maximize profit, all companies (not only competitive businesses) must make two decisions. First, the company determines the quantity at which its profit is highest. Profit is maximized when marginal income is zero, or, equivalently, when marginal income equals marginal cost. Second, the company decides whether to produce by any means" (Holcombe, 2009).

MC = MR means a firm's profits will be the largest when the extra revenue gained from one more device sold is exactly equal to the extra costs incurred from creation the additional unit of output. A firm in a correctly competitive market is a price taker. Whatever the amount of end result it offers, it cannot influence the marketplace price so marginal income will be equal to average earnings, demand and price. In Diagram 1. 1, Q1 is the profit-maximising level of outcome and P is the profit-maximising price. When a firm produces significantly less than output Q1, marginal earnings surpasses marginal cost. The firms may then gain more profit by increasing its end result. However, producing any result beyond point Q1 results marginal cost being greater than marginal revenue. Therefore, the firm would be experiencing deficits and may subsequently resort to reducing its result up to point Q1 where marginal cost and marginal revenue are equal. Quite simply, producing any more would incur more costs than the revenue made and producing any less would result in the increased loss of potential profits. Thus, it could be concluded that a firm's gains are maximised at a level of output where its marginal income exactly includes its marginal cost.

Take for example, a small-time farmer growing chickens to be sold at a market nearby. There are lots of farmers likewise so he is unable to impact the market price for chickens at 2 pounds per kilo. No matter how many kilos of chickens he provides, his average income and marginal earnings are identical at 2 pounds. Guess that when a sizable exporter who grows chickens on a bigger scale markets 100 kilos of poultry on the marketplace, the price of producing and reselling the 100th kilo is 1. 60 pounds. If the farmer determine against providing the 100th kilo, he loses 40 pence of profit. However, suppose that when a 101th kilo and 102nd kilo are sold, total costs increase to 2 pounds and 2. 40 pounds respectively. The marketing of the 102nd kilo ends in profits slipping by 40p whereas the 101th kilo will not affect the total gains. Therefore, the 101th kilo is the quantity sold of which income are exactly maximised.

Profit-Maximisation vs. Shareholder Wealth

It is important to distinguish between profit maximisation and shareholder wealth. The former is seen as a short term goal, to be performed within a given period of time whereas the second option is more of any long-term objective. From the World Academy Online article, "A firm may take full advantage of its short-term earnings at the trouble of its long-term success" (World Academy, 2012). Within the short-run, decisions are made to ensure that income are maximised, even at cost of the firm's sustainability of success in the long-run. For instance, the business Purdue Pharma who made a powerful narcotic painkiller OxyContin advertised the drug and claimed that is was not addictive even although company's executives understood it was a false claim. The business's purpose behind this unethical take action was to improve sales and maximise income in the short-term. However, this came up at the expense of the business as Purdue Pharma and its own executives were convicted of criminal charges and fined heavily (Miller, 2012). The company was demolished in its work to fulfil its short-term aim. Shareholder wealth is regarded as a long-term objective because shareholders are concerned about profits now as well as in the foreseeable future and are therefore, considering the sustainability of the firm.

In large businesses, the organization is run by directors and managers who are answerable to shareholders. Those that run the organization might not have interests, eyesight or goals that align with those of the shareholders (Berle & Means, 1932). "This perception is aided by recent reports of the 25-calendar year jail sentence passed down to ex - World. Com employer Bernard Ebbers for his part in the fraud that caused the $11 billion collapse of that company" (McConvill, 2005). They could prioritise maximising short-term earnings or even to maximise sales income (Baumol, 1958) as they may be driven by self-interest. "In company theory, the agent may be succumbed to self-interest, opportunistic behavior and falling brief of congruence between the aspirations of the main and the agent's pursuits" (Abdullah & Valentine, 2009). Some organizations pay their professionals bonuses based on the year's sales revenue or encourage them with non-monetary benefits such as creature comforts. Ergo, higher sales revenue for the year means a greater bonus or more benefits for this group. Shareholders on the other hands have a tendency to be keener on the firm's profitability in the long-run to ensure continuous returns on their investment. Professionals do not stand to benefit immediately from shareholder riches maximisation unless they own stocks in the business itself. Thereby, providing rise to conflict between shareholders who own the organization and managers who run the firm. "This conflict is called the principle/agent problem" (Peavler, 2012). This reinforces the view that under such circumstances, pressure does exist to a certain extent.

To enable long-term income maximisation or shareholder riches, short-term revenue maximisation may have to be forgone. Thus, stress may occur between these two objectives. This is so because purchases, new capital, inventions, research and development for example, could assist in long-term progress and profitability and therefore, maximising shareholder wealth. However, in order to funding these long-term profit-making means, short-term profits may need to be sacrificed. On top of that, short-term revenue maximisation will not take risk into consideration and will neglect communal responsibility which many economists would consider as necessary in search of shareholder riches maximisation in the long run. High risk decisions may be looked at favourable a long as they assure high returns even if indeed they jeopardise the company's image or well-being. Large banking companies especially those in america were often used as proof this subject when they made socially irresponsible and risky decisions by buying sub-prime mortgages and derivatives. Whilst they made income in the short-run, shareholder prosperity was far from maximised in the long-run. As a result, these banks suffered and many failed as supported by the extract from the New York Times. "Funds and banks surrounding the world took strikes because they purchased bonds, or risk related to bonds, supported by bad mortgage loans, often bundled into financial musical instruments called collateralized debt obligations, or C. D. O. 's" (NY Times, 2007).

On the in contrast, there could not be pressure between these two targets if short-run income maximisation was not the firm's primary objective or if it was complementary to the long-run shareholder wealth objective. Theoretically, companies are assumed to possess information, market electricity and the bonuses to determine end result as well as costs that would optimise profits. In the real world, firms are always confronted with imperfect information about demand and cost conditions and uncertainty. Under such conditions, a company may be contented with satisficing profits while making enough to ensure the ongoing growth and development of the company which would donate to shareholder riches in the long-term. Large businesses especially, have complicated structures in which profit-maximisation is a much too simple assumption to be produced. Consequently, such companies could have other objectives on the top of these list such as revenue maximisation, managerial electricity maximisation or maybe even seek to satisfice each goal rather than maximise as depicted by behavioural theories of the company. However, it may be argued that shareholders would support the profit-maximising goal and in exchange, the gains made would be reinvested in new ventures, enhancements and R&D assignments. With respect to this theory, the more profit the business makes, a lot more funds are for sale to purposes which would improve the value and price of the company's shares in the future and hence, shareholder wealth.

Whether or not pressure or conflict prevails between short-run revenue maximisation and long-run shareholder riches depends upon several factors which ought to be taken into account. How big is the firm and its position on the market in terms of market show for example, could effect the nature and top priority of its objective(s). The firm's objective(s) may change to be able of importance with regards to the economy's business routine and health and the firm's recent and present performance. Companies may modify the priority of these goals in a quarterly or gross annual basis to suit current improvements and progress of the firms of the organizations with respect to their challengers. Also, different organizations have an alternative structure and degree of complexity, governed by different groups of directors, professionals and shareholders - which would effect their main aim. Addititionally there is the likelihood that some modern-day firms follow a variety of targets and seek to satisfice rather than maximise as advised by Cyert & March's behavioural theory (Argote & Greve, 2007). In large companies, the magnitude of divorce between ownership and control would affect the severe nature of the principal-agent problem when it prevails. Some firms show characteristics of Oliver E. Williamson's style of managerial discretion which implies that professionals design and implement policies in discretion to maximise their personal energy instead of targeting the maximisation of gains which at the end of your day, maximises shareholder wealth (Williamson, 1963).


Does tension can be found between short-run revenue maximisation and long-run shareholder riches? Well, this will depend. The neo-classical style of profit-maximising holds to a certain degree but in real life, its assumptions are too simplistic to be coupled with the complexity of firms. Upon breaking down the assumptions of the neo-classical theory of the firm, profit-maximising as the best goal of organizations may well not be as rational as it seems. "The neoclassical model is unsatisfactory, I really believe, not only because its assumptions are unrealistic, but also because it misinterprets human being action within the setting up of the company" (Anderson, 2003). When shareholder prosperity depends upon revenue manufactured in the short-run, both targets may be conflicting. In order to achieve shareholder prosperity maximisation, managers may need to make corporate and business decisions which would come at the expense for short-term gains. Alternatively, the two objectives can be a go with of the other if gains made in every time period are independent of each other. Short-term revenue maximisation could eventually lead to long-term income maximisation and thus, shareholder prosperity maximisation. It is also possible that there may be little or no tension if earnings maximisation is not the firm's main goal. Moreover, there are other alternatives which may be more viable and realistic in practice such as managerial energy maximisation (Williamson), sales revenue maximisation (Baumol), and objectives satisficing (Cyert & March) or perhaps a behavioural alternate. Either of the could not in favor of long-run shareholder prosperity and pose even greater menace to shareholders prosperity.

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