Firms are organisations with the purpose of bringing together the factors of production to produce output. So what motivates a firm to produce at particular levels of output, and at what price?
Traditional economic analysis has tended to start from the premise that firms set out with the objective of maximising profits. In analysing this, economists define profits as the difference between the total revenue recieved by a form and the total costs that it incurs in production.
profits = total revenue – total costs
Total revenue here is seen in terms of the quantity of the product that is sold multiplied by the price they sold at. Total cost includes fixed and variable costs that have already been discussed. However, one important item of costs should be highlighted before going any further.
Consider the case of a sole proprietor – a small local business. It seems reasonable to assume that such a firm will set out to maximise its profits. However, from an entrepenur’s prospecitve there is an opportunity cost of being in business, which may be seen in terms of the the earnings that the proprietor could make in an alternative occupation.
The same procedure applies to cost curves for other sorts of firm. In other words, when economists refer to costs, they include the rate of return that a firm needs to make to stay in the market in the long run. Accountants dislike this, as opportunity cost cannot be identified as an explicit item in the accounts. This part of the costs is known as the normal profit. Profits made by a firm above that level are known as supernormal profits, abnormal profits, or economic profits.
In the short run, a firm may choose to stay in a market even if it is not covering its opportunity costs, provided its revenues are covering its variable costs. Since the firm has already incurred fixed costs, if it can cover its variable costs in the short run it will be better off remaining in business and paying off part of the fixed costs. Thus, the level of average variable costs represents the shut-down price, below which the firm will exit the market in the short run.
How does a firm choose its output level if it wishes to maximise profits?
Suppose a firm is a relatively small player in a big market, and it has no influence over the price of the product.Its total revenue is therefore proportional to the amount that it sells. If it faces the shape of the short run total cost curve that was introduced earlier in the chapter, its output decision can be analysed.
To maximise profits, the firm needs to choose the output level at which the total revenue curve is as far above the total cost curve as possible.
This happens at price point A, which is the point where the slope of TC is the same as the slope of TR.
Notice that the slope of TC is in fact the short run marginal cost, as noted earlier. Simillarly, the slope of TR is marginal revenue; this is the additional revenue that the firm gains from selling an additional unit of output. Thus it can be seen that profits will be maximised when marginal cost is equal to marginal revenue – with one provisio: total revenue must exceed total cost. After all, the slops of TC and TR are also equal earlier in the curve, but at that point TC far exceed TR, leading to the maximal loss.
An alternative way of looking at this decision is to draw the marginal revenue and marginal cost curves.
Becuase it is assumed that the firm cannot affect price, the MR curve is constant, and equal to the price sold at. The MC curve is the same as usual.
You can clearly see the profit maximising point, when MC = MR. If the firm is producing less output than this, it will find that the marginal revenue it can gain from producing one extra unit exceeds the cost of producing it, so profits will increase. In contrast, if a firm is producing beyond its profit maximising point, it will find that the marginal revenue it gains from selling an extra unit fails to cover the cost of producing the unit, so it will not pay for the firm to produce beyond MC=MR.
The MC = MR rule is a general rule for firms that wish to maximise profits, and it holds in all market situations. For example, suppose a firm faces a downward sloping demand curve for its product, such that it can sell more by reducing the price.Profits are again maximised where the slopes of TC and TR are equal, with TR exceeding STC.
The principal-agent problem
The discussion so far seems reasonable when considering a relatively small, owner-managed, firm. In this context, profit maximisation makes sense as the firm’s motivation.
However, for many larger firms – especially public limited companies – the owners may not get involved in the running of the business. This gives rise to the principal-agent problem. In a public limited company, the shareholders delegate the day-to-day decisions concerning the operation of the firm to managers who act on their behalf. In this case, shareholders are the principals, and the agents are the managers who run things for them.
If the agents are fully in sympathy with the objectives of the owners there is no problem, and the managers will take exactly the decisions that the owners would take. Problems arise when there is conflict between the aims of the owners and those of the managers.
One simple explanation of why this problem arises is that the managers like a quiet life, and therefore do not push for the absolutely profit-maximising position, but do just enough to keep the shareholders off their backs. Herbert Simon refered to this as ‘satificing’ behaviour, where managers aim to produce satisfactory profits rather than maximal profits.
Another possibility is that managers become negligent because they are not fully accountable. One manifestation of this may be organisational slack in the organisation: costs will not be minimised as the firm is not operating as efficiently as it could. This is an example of what is called X-inefficiency. This is when costs for a given level of output are above that of the long-run average costs.
Some writers have argued that the managers may be pursuing other objectives. For example, some managers may enjoy being involved in the running of a large business, and may prefer to see the firm gain market share – perhaps beyond the profit maxmising level. Others like to see their status rewarded and so will want to divert part of the profits into managerial perks – large offices, company cars and so on. Or they may feel that having a large staff working for them increase their prestige inside the company. These sorts of activity tend to reduce the profitability of firms.
William Baumol argued that managers may set out with the objective of maximising revenue.
A revenue maximising firm will produce more output than a profit maximising one, and will need to charge a lower price in order to sell the extra output.
Bauol noted that shareholders may not be too pleased about this. The way the firms behaves then depends upon the degree of accountability that the agents have to the principles. For example, shareholders may have sufficient power over their agents to insist on some minimum level of profits. The result may then be a compromise solution between the principals and their agents.
Revenue maximisation occurs when an additional unit of output provides no extra revenue. MR =0
In some cases, managers may focus more on the volume of sales than on the resulting revenues. This could lead to output being set even higher – up to the point where it breaks even, where TC = TR beyond MC = MR. Remember, the total cost includes normal profit – the opportunity cost of the resources tied up in a firm. The firm would have to close down if it did not cover this opportunity cost in the long run.
Again, the extent to which the managers will be able to pursue this objective without endangering their position in the firm depends on how accountable they are to their shareholders. Remember that managers are likely to have much better information about a market that the shareholders, who view a firm remotely. This may be to the managers advantage.
An important question is what this analysis implies for the efficiency of markets. How likely are firms to produce in ways that bolster the overall efficiency of the markets in which they work in to allocate resources?
Productive efficiency has two conditions. First it requires that firms choose an appropriate set of factor inputs. Second, it requires that those inputs are used in the best way possible in order to minimise costs. These requirements are met in a market if firms are operating that their minimum long-run average cost.
Allocative efficiency in an individual market requires that firms charge a price that is equal to marginal cost. To determine whether this condition will be met, it is necessary to see how prices are set, which will be explained in the forthcoming posts.