Session V

Objectives of Firm
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Objectives of the Firm
Why do people do business?

What motivates the owners /investors / promoters to take so much

of risk and conduct their own businesses, rather than going for a
secured employment?

Is it only maximization of profits that drives businesses?

◦ Or is it something beyond?

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Profit Maximization Theory
Objective of business is generation of the largest amount of
Profit = (Total Revenue-Total Cost)
Traditionally, efficiency of a firm measured in terms of its profit
generating capacity

Criticism
▪Confusion on measure of profit
▪Validity questioned in competitive markets

3
Baumol’s Theory of Sales Revenue
Maximization
In competitive markets firms aim at maximizing revenue through maximization
of sales

Sales volumes determine market leadership in competition

Manager’s salary and other benefits linked with sales volumes, rather
than profits

Criticism
▪Insufficient empirical evidence

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 Marris’ Hypothesis of Maximization of
Growth Rate

Two sets of goals:

▪Owners (shareholders) aim at profits and market share (Uo )
▪Managers aim at better salary, job security and growth (Um)
Both achieved by maximizing balanced growth of the firm (G), which depends
on Growth rate of demand for the firm’s products (GD) and Growth rate of
capital supply to the firm (GC)
G = GD= GC Where,
d = diversification,
GD= f(d, k) k = success rate,
r = financial
GC= f(r, π) security ratio,
π = constant rate
of profit increase 5
…Marris’ Hypothesis of Maximization of Growth
Rate
Constraints in the objective of maximization of balanced
growth:
▪Managerial Constraint : Non availability of managerial skill sets
in required size creates constraints for growth
▪Financial Constraint : debt equity ratio (r1), liquidity ratio (r2)
and retained profit ratio (r3)

Um = f(Salary, Power, Status, Job Security)

U0 = f(Profit, Market Share, Brand Image)

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Williamson’s Model of Managerial Utility
Function
Managers apply their discretionary power to maximize their own utility function
▪Constraint of maintaining minimum profit to satisfy shareholders
Utility function of managers (Um) depends on: salary, Job security, power of discretionary
investment (ID)
Um = f (S, M, ID)
ID = πD(πD is discretionary profit) Where,
π D = (Actual profit – Minimum profit) – Tax
S=Salary,
Therefore : M=Managerial
Um = f (S, πD) Emoluments,

An increase in S is only possible by decrease in πDand vice versa.

Managers’ try to find an optimum combination of S and πD

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Behavioral Theories
Simon’s Satisficing Model
Biggest challenge before modern businesses is lack of
full information and uncertainty about future
The objective of maximizing either profit,or sales,
or growth is not possible.
▪they act as constraints to rational decision making
▪the firm has to operate under "bounded rationality"
▪can only aim at achieving a satisfactory level of profit, sales and growth

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Behavioural Theories
Model by Cyert and March
Apart from dealing with inadequate information and uncertainty,
businesses also have to satisfy a variety of stakeholders, who have
different and oft conflicting goals
‘Satisficing behaviour’ aims at satisfying all stakeholders.
Managers form an Aspiration level on basis of past experience,
past performance of the firm, performance of other similar firms,
and future expectations

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Reasonable Profit Objective
Profit is necessary in the long run
◦ It is an indicator of the financial health of the company and growth

Shareholders, creditors and other investors are satisfied that

the firm is growing and their capital is well-invested
The possibility of profit maximization may attract competition, while
reasonable profit may make the market less attractive
Workers and unions refrain from demanding higher wages as profits
are not huge
Thus a minimum reasonable profit is a must for any firm
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