Topic-1-Objectives of Firms

Segment: Pricing in Mass Markets
Topic: Objectives of Firms

MBO103 – Managerial Economics
Table of Contents
1. Profit Maximisation Model ..................................................................................................... 5

2. Economist Theory of the Firm .............................................................................................. 12
3. Cyert and March’s Behaviour Theory ................................................................................... 13
4. Marris’ Growth Maximisation Model ................................................................................... 16
5. Baumol’s Static and Dynamic Models .................................................................................. 19
6. Williamson’s Managerial Discretionary Theory ................................................................... 22
7. Summary ................................................................................................................................ 24
8. Glossary .................................................................................................................................. 25
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Introduction
In the previous segment, we learnt cost analysis. Cost analysis indicates the various amounts of
costs incurred to produce a particular quantity of output in monetary terms. The various kinds
of cost concepts help a manager to take right decisions. Cost function explains the relationship
between the amounts of costs to be incurred to produce a particular quantity of output.
In this topic, we will discuss objectives of firms. A business firm is an economic unit. It is a
producing unit. It converts inputs into outputs. It is a legal entity on the basis of ownership and
contractual relationships organised for production and sale of goods and services. All business
units are set up and managed by people and are called by various names like shops, firms,
enterprise, production and business concerns etc. They can take several forms like sole trader,
partnership concern, joint-stock company, cooperatives or even public utilities. They produce
and supply different goods and services for the direct satisfaction of consumers.
Each firm lays down its own objectives. They are fundamental to the very existence of a firm.
The objectives are the end-point towards which rational activity is carried out. They indicate
the very existence of a firm and guide the actions of a firm. They indicate how a firm has to
organise its activities and perform its functions.
A modern business unit has multiple objectives and they are multi- dimensional in nature.
Some of them are competitive while others are supplementary in nature. A few other
objectives are mutually interconnected, and a few others are opposing in nature. These
objectives are determined by various factors and forces like corporate environment, socio-
economic conditions, the nature of power in the organisation and extraneous conditions, and
constraints under which a firm operates.
Case Let (Continued from segment 2)

In the previous topic, we saw that Ramesh was asked to analyse the changes in costs due to increase in
production. Ramesh undertook the cost analysis and presented the report to his superior. Ramesh had
had to rely on various estimates of costs to prepare his report. He realised that it was practically very
difficult to estimate the costs of some fixed factors and variable factors and he had to rely on ballpark
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information/ data. Upon reading the report, Ramesh’s superior asked him to provide estimates of
revenue at different production and sales levels by considering the sale price of various traverse rods
which were sought to be produced. While preparing his report, Ramesh met Akshay, who was a
consultant in business strategy. Akshay asked Ramesh about the short-term and long-term goals and
objectives of Ramesh’s firm. Ramesh could not respond adequately and, this led him to realise that
although he was an employee of his firm for quite some time now, he was unaware of the objectives of
his firm. This set him thinking on why business firms exist.
Economists, over a period of time, have developed various theories and models to explain
different kinds of goals of modern firms. Broadly speaking they can be divided in to three
groups. They are as follows:
1. Profit maximisation model

2. Managerial theories or models
3. Behavioural theories or models
Let us study some of the important theories under each category.
Learning Objectives
At the end of this topic, you will be able to:

• explain the background under which a firm lays down its multiple objectives
• explain how modern business units have several objectives instead of having a single
objective
• analyse how profit-maximisation is the basic objective of a firm
• determine the suitable objectives from amongst the many objectives that could be
adopted by a firm.
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1. Profit Maximisation Model

In this section, we will discuss the profit maximisation model. Profit-making is one of the most
traditional, basic and major objectives of a firm. Profit- motive is the driving force behind all
business activities of a company. It is the primary measure of success or failure of a firm in the
market. Profit earning capacity indicates the position, performance and status of a firm in the
market. In spite of several changes and development of several alternative objectives, profit
maximisation has remained as one of the single most important objectives of the firm, even
today.
Both small and large firms consistently make an attempt to maximise their profit by adopting
novel techniques in business. Specific efforts have been made to maximise output and
minimise production and other operating costs. Cost reduction, cost cutting, and cost
minimisation has become the slogan of a modern firm.
The profit maximisation model is a very simple and unambiguous model. It is the ideal model
to explain the normal behaviour of a firm.
Main propositions of the profit-maximisation model
The model is based on the assumption that each firm seeks to maximise its profit given certain
technical and market constraints. The following are the main propositions of the model:
In this section, we will discuss the profit maximisation model. Profit-making is one of the most
traditional, basic and major objectives of a firm. Profit- motive is the driving force behind all
business activities of a company. It is the primary measure of success or failure of a firm in the
market. Profit earning capacity indicates the position, performance and status of a firm in the
market. In spite of several changes and development of several alternative objectives, profit
maximisation has remained as one of the single most important objectives of the firm, even
today.
Both small and large firms consistently make an attempt to maximise their profit by adopting
novel techniques in business. Specific efforts have been made to maximise output and
minimise production and other operating costs. Cost reduction, cost cutting, and cost
minimisation has become the slogan of a modern firm.
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The profit maximisation model is a very simple and unambiguous model. It is the ideal model
to explain the normal behaviour of a firm.
Main propositions of the profit-maximisation model
The model is based on the assumption that each firm seeks to maximise its profit given certain
technical and market constraints. The following are the main propositions of the model:
1. A firm is a producing unit which converts various inputs into outputs of higher value, by
employing certain techniques of production.
2. The basic objective of each firm is to earn maximum profit.
3. A firm operates under given market conditions.
4. A firm selects that alternative course of action which helps to maximise consistent profits.
5. A firm attempts to change its prices, input and output quantity to maximise its profit.
The model
Profit-maximisation implies earning highest possible amount of profit during a given period of
time.
A firm should always give optimum productivity in order to get a huge amount of profit both in
the short run and long run depending upon various factors like internal and external. The short
run and long run objectives should always be balanced. In the short run, a firm is able to make
only slight or minor adjustments in the production process as well as in business conditions.
The plant capacity in the short run is fixed and as such, it can increase its production and sales
by intensive utilisation of existing plants and machineries, having overtime work for the
existing staff, etc.
Thus, in the short run, a firm has its own technical and managerial constraints. But in the long
run, as there is plenty of time at the disposal of a firm, it can expand and add to the existing
capacities; build new plants; employ additional workers; etc. to meet the rising demand in the
market. Thus, in the long run, a firm will have adequate time and ample opportunity to make
all kinds of adjustments and readjustments in production process and in its marketing
strategies.
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It is to be noted with great care that a firm has to maximise its profits after considering various
factors. Such factors include:
1. Pricing and business strategies of rival firms and their impact on the working of the given
firm.
2. Aggressive sales promotion policies adopted by rival firms in the market.
3. Demands of workers for payment of higher wages and salaries leading to rise in operation
costs.
4. Government controls and takeovers on monopolistic and exploitative business practices.
5. Maintaining the quality of the product and services to the customers.
6. Taking various kinds of risks and uncertainties in the changing business environment.
7. Adopting a stable business policy.
8. Avoiding any sort of conflict between short run and long run profits in the business policy
and maintaining proper balance between them.
9. Maintaining the firm’s reputation, name, fame and image in the market.
10. Profit maximisation is necessary in both perfect and imperfect markets. In a perfect
market, a firm is a price-taker and under imperfect market, it becomes a price-searcher.
A firm has to ensure that these factors do not get violated by any policy adopted by the firm
for maximising its profits.
Assumptions of the model
The profit maximisation model is based on three important assumptions. They are as follows:
1. Profit maximisation is the main goal of the firm.
2. Rational behaviour on the part of the firm to achieve its goal of profit maximisation.
3. The firm is managed by owner-entrepreneur.
Determination of profit – maximising price and output
Profit maximisation of a firm can be explained in two different ways.
a) Total revenue and total cost approach
b) Marginal revenue and marginal cost approach
Let us discuss the approaches in detail.
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TR and TC approach
Profits of a firm are estimated by comparing total revenue and total costs. Profit is the
difference between TR and TC. In other words, excess of revenue over costs is the profits.
Profit = TR – TC. If TR is equal to TC, in that case, there will be breakeven point. If TR is less than
TC, in that case, a firm will be incurring losses.
MR and MC approach
In this case, we compare the revenue earned from one additional unit and cost incurred to
produce one additional unit of output. A firm will be maximising its profits when MR = MC and
MC curve cuts MR curve from below. If MC curve intersects the MR curve from above, either
under perfect market or under imperfect market, then undoubtedly MR equals MC but, total
output will not be maximised and hence total profits also will not be maximised. Hence, two
conditions are necessary for profit maximisation:
1. MR = MC
2. MC curve intersects MR curve from below
It is clear from the following diagrams. Figures 1 and 2 depict the two conditions necessary for
profit maximisation, respectively.
Fig. 1: Cost/Revenue Curve: “MR = MC”
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Fig.2: Cost/Revenue Curve: “MC Intersecting MR from Below”

Justification for profit maximisation
The model for profit maximisation can be justified on account of the following reasons:
1. Basic objective of traditional economic theory – The traditional economic theory assumes
that a firm is owned and managed by the entrepreneur himself and, the entrepreneur always
aims at maximum return on his capital invested in the business. Hence, profit-maximisation
becomes the natural principle of a firm.
2. Firm is not a charitable institution – A firm is a business unit. It is organised on commercial
principles. A firm is not a charitable institution. Hence, it has to earn reasonable amount of
profits.
3. Most realistic prediction of price-output behaviour – This model helps to predict usual and
general behaviour of business firms in the real world as it provides a practical guidance. It also
helps in predicting the reasonable behaviour of a firm with more accuracy. Thus, it is a very
simple, plain, realistic, pragmatic and most useful hypothesis in forecasting price output
behaviour of a firm.
4. Necessary for survival – It is to be noted that the very existence and survival of a firm
depends on its capacity to earn maximum profits. It is a time-honoured hypothesis and, there
is common agreement among businessmen to make highest possible profits both in the short
run and long run.
5. Achievement of other objectives – In recent years, several other objectives have become
much more popular and all these objectives have become highly relevant in the context of
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modern business setup. But it is to be remembered that they can be achieved only when a firm
is making maximum profits for e.g., a firm, in the initial stages of its operations, may focus on
maximising its market share by lowering its prices and offering attractive entry offers to
customers. Similarly, at other points of time, the business firm may take decisions to maximise
returns over the long run (or value) while even compromising on immediate profits, e.g.,
through mergers and acquisitions.
Criticisms
There are certain short comings in this model for which it has received criticism. The reasons
for criticism of the model are as follows:
1. Ambiguous term – The term profit maximisation is ambiguous in nature. There is no clear-
cut explanation whether a firm has to maximise its net profit, total profit or the rate of profit in
a business unit. Again, maximum amount of profit cannot be precisely defined in quantitative
terms.
2. It may not always be possible – Profit maximisation, no doubt, is the basic objective of a
firm. However, in the context of highly competitive business environment, it may not be always
possible for a firm to achieve this objective. Other objectives like sales maximisation, market
share expansion, market leadership, building its own image, name, fame and reputation,
spending more time with members of the family, enjoying leisure, developing better and
cordial relationship with employees and customers etc. also, have assumed greater
significance in recent years.
3. Separation of ownership and management – In many cases, we come across business units
which are organised on partnership or are joint-stock companies or organised on cooperative
basis. In case of many large organisations, ownership and management is clearly separated and
they are run and managed by salaried managers who have their own self interests and as such,
profit maximisation may not become possible.
4. Difficulty in getting relevant information and data – In spite of revolution in the field of
information technology, it may not be always possible to get adequate and relevant
information to take right decisions in a highly fluctuating business scenario. Hence, profits may
not be maximised.
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5. Conflict in inter-departmental goals – A firm has several departments and sections headed
by experts in their own fields. Each of the departments will have its own independent goals
and frequently, there is a possibility of clashes between the interests of different departments
and profits may always not be maximised.
6. Changes in business environment – In the context of highly competitive and changing
business environment and changes in consumers’ tastes and requirements, a firm may not be
able to cope up with the expectations and adjust its policies and, profits may not be
maximised.
7. Growth of oligopolistic firms – In the context of globalisation, growth of oligopoly firms has
become so common through mergers, amalgamations and takeovers. Leading firms dominate
the market and the small firms have to follow the policies of the leading firms. Hence, in many
cases, there are limited chances for making maximum profits.
8. Significance of other managerial gains – Salaried managers have limited freedom in
decision making process. Some of them are unable to forecast the right type of changes and
meet market challenges. They are more worried about their salaries, promotions, perquisites,
security of jobs, and other types of benefits. They may lack strong motivation to generate
higher profits as profits would go to the organisation. They may be contented with only
satisfactory level of profits rather than maximum profits.
9. Emphasis on non-profit goals – Many organisations stress on the achievement of non-profit
goals. From the point of view of today’s business environment, productivity, efficiency, better
management, customer satisfaction, durability of products, higher quality of products and
services, etc. have gained importance to cope with business competition. Hence, emphasis has
shifted from profit maximisation to other practical aspects.
10. Aversion to reduction in power – In case of several small businesses, the owners do not
want to share their powers with many new partners and hence, they try to keep maximum
powers in their hands. In such cases, retaining more power becomes more important than
profit maximisation.
11. Official restrictions over profits of public utilities – Public utilities or public corporations are
legally prohibited to make huge profits in many developing countries like India.
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Thus, it is clear that a firm cannot maximise its profits always. There are many constraints in
the background of multiple objectives. Each one of the
2. Economist Theory of the Firm

In this section, we will discuss the economist theory of the firm. According to the economist
theory of the firm, a firm is a producing unit. It transforms or converts all kinds of inputs into
outputs. The basic function of a firm is to produce those goods and services which are
demanded by consumers in the market. A firm is a business unit and it is organised on
commercial principles. By producing and selling different goods and services, the firm aims at
making profits.
According to this theory, a traditional firm is a group with a particular organisational and
management structure, having command over its own property rights. It is a legal entity on the
basis of ownership and contractual relationship organised for production and sale of goods and
services. In olden days, a firm was called by various names such as shops, firms, enterprise,
production and business concerns, etc., but today, it is organised on various forms like a sole
trader, partnership concern, joint-stock company, cooperative society, etc.
A firm is formed, run and managed by an owner, employer or an entrepreneur who has the
following characteristics:
1. He has the legal permission to run an enterprise.
2. He can enter into contract with any group of people who supply productive resources.
3. He can take his own decisions to maximise his economic gains.
4. He is entitled to enjoy the residual income after making payments to all productive
resources in the form of rent, wages and salaries and interest.
5. He can transfer his rights and obligations to other individuals on the basis of contracts.
6. He can direct and dictate the suppliers of productive resources in the desired manner by
entering into legal contracts.
7. He can change the nature of management according to his convenience.
8. He has all the rights to make changes in his organisation which he feels the best. He can
consult others, or he can take his own final decisions.
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The traditional or classical firm basically engages itself in various kinds of economic activities
which help in maximising its profits. It concentrates on wealth creation and through it, surplus
creation. Surplus value is nothing but the difference between the value of the final product and
the value of various inputs employed in the production process. Surplus generation is possible
when the firm produces maximum output with minimum costs. Hence, a firm works out the
ideal factor combination to avoid all kinds of wastages, cut down costs and maximise its
output. When the firm produces maximum output with minimum costs, it reaches the
equilibrium position. This is possible when marginal revenue is equal to marginal cost. At the
equilibrium point, it is said that a firm will be maximising its profits. The nature of working of a
firm depends on several factors like number of firms in the market, size of the firm, volume of
production, entry and exit of firms, degree of competition, existence of alternative substitutes,
prices of goods, etc.
Thus, the traditional or the classical firm aims at profit maximisation and over the years, this
objective has been replaced by profit optimisation.
3. Cyert and March’s Behaviour Theory

In this section we will discuss about the behaviour theory. It is another alternative non-profit
maximising theory that has been developed by Cyert and March. The theory makes an attempt
to explain the behaviour of inter- group conflicts and their multiple objectives in an
organisation. Basically, this theory explains the usual and normal behaviour of different groups
of people who work in an organisation having mutually opposite goals.
Prof. Simon has developed the initial behavioural model and, Prof. Cyert and March have
further elaborated the theory, in their book “Behavioural Theory of the Firm”, published in
1963.
Cyert and March explain how complicated decisions are taken in big industrial houses under
various kinds of risks and uncertainties in an imperfect market in the background of limited
data and information. The organisational structure, goals of different departments,
behavioural pattern and internal working of a big and multi-product firm differs from that of
small organisations. The various kinds of internal conflicts and problems faced by these
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organisations would certainly affect the decision-making process of these organisations. They
also explain how there are certain common problems faced by similar organisations in an
industry and their effects on the internal working of each individual organisation and their
decision making processes.
Cyert and March consider the modern firm as a multi-product, multi-goal and multi-decision
making coalition business unit. Like a coalition government, it is managed by a number of
groups. The group consists of shareholders, managers, workers, customers, suppliers,
distributors, financiers, legal experts, etc. Each group is independent by itself and has its own
set of objectives and they try to maximise their individual benefits. For example, shareholders
expect faster growth of the company and higher dividends; workers expect maximum wages
and minimum work, better working conditions, welfare measures; managers want higher
salary, greater power, autonomy in day to day working, dominance, control, etc; suppliers
expect quick and immediate payments, etc. Contributions made by each one of the groups is
equally important in carrying out the activities of a firm. In their view, out of several groups,
the most important ones are the shareholders, workers and managers in an organisation.
It is quite clear that goals of each one of the groups is multiple, conflicting and opposite in their
nature. Each one of the groups, based on their past experiences and success and, availability of
limited resources at the disposal of a firm, would arrange their demand on the basis of
priorities. Most urgent demands are highlighted, and low priority demands are postponed to
later periods. The management may honour a few demands of a few groups and postpone the
demands of other groups in view of financial constraints. This may create heartburns and
conflict between different groups in the same organisation.
If actual performance and achievements of the organisation is much better than expected
aspirations and target level, there will be an upward revision in their demands and vice-versa.
Thus, there is a strong linkage between the expected and actual demand of each group in the
organisation, past success and future environment. Each group makes an attempt to achieve
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its demand in its own way. Through the process of hard bargaining, a winning coalition is
formed, and the broad objectives are set out by the management.
Cyert and March suggest the following methods to overcome the conflicts of different groups
and enable smooth working of the organisation. They are as follows - Demands of each group
may be separated from that of the other and separate attempts must be made to fulfil them so
that their impact on the whole organisation may be avoided. For example, they would grant
higher monetary rewards for various factor inputs like higher wages, salaries and bonus to
workers, grant of other perquisites to keep them happy. They may also grant side payments to
different departments to carry on their work smoothly, e.g. more funds may be released to
R&D for buying computers, equipment, etc; share holders may be granted higher dividends;
managers given more powers, more autonomy, higher salaries, lavish and luxurious air-
conditioned offices, vehicles, and various kinds of facilities to keep them happy. They are called
as slack payments. The management may follow the policy of sequential attention. The
management may also tackle the problem by decentralising the decision making process.
Cyert and March are of the opinion that out of several objectives, a firm has five important
goals. They are as follows:
1. Production goal – Production is to be organised on the basis of demand in the market.
Neither should there be overproduction nor underproduction but a quantity that is just
adequate to meet the market demand. Development of excess capacity, over-utilisation of
capital assets and lay-off of workers, etc should be avoided.
2. Inventory goal – Inventory refers to stock of various inputs. In order to ensure continuity in
production and supply, a certain minimum level of inventory has to be maintained by a
firm. Neither surplus stock nor shortage of different inputs should occur. Proper balance
between demand and supply is to be maintained.
3. Sales goal – There should be adequate sales in any organisation to earn reasonable amount
of profits. In order to create demand, sales promotion policies may be adopted from time
to time.
4. Market-share goal – Each firm has to make consistent effort to increase its market share to
compete successfully with other firms and make sufficient profits.
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5. Profit goal – This is one of the basic objectives of any firm. The very survival and success of
the firm would depend upon the volume of profits earned by it.
The above-mentioned objectives would undergo changes over a period of time in the
background of modern business environment. Hence, decision making would become complex
and complicated.
It is quite clear that each business organisation has its own set of goals. These goals would
depend on the ever-changing demands of different groups who have their own conflicting
objectives.
Demerits
The demerits of Cyert and March’s behaviour theory are as follows:
1. The theory fails to analyse the behaviour of the firm, but it simply predicts the future
expected behaviour of different groups.
2. It does not explain equilibrium of the industry as a whole.
3. It fails to analyse the impact of the potential entry of new firms into the industry and the
behaviour of the well-established firms in the market.
4. It highlights short run goals rather than long run objectives of an organisation.
Thus, there are certain limitations to this theory
4. Marris’ Growth Maximisation Model

In this section, we will discuss the growth maximisation model by Prof. Marris. Profit-
maximisation is a traditional objective of a firm. Sales maximisation objective is explained by
Prof. Baumol. On similar lines, Prof. Marris has developed an alternative growth maximisation
model. It is commonly seen that each firm aims at maximising its growth rate, because this
goal would answer many of the objectives of a firm. Marris points out that a firm has to
maximise its balanced growth rate over a period of time.
Marris assumes that the ownership and control of the firm is in the hands of two groups of
people, i.e., owners and managers. He further points out that both of them have two
distinctive goals. Managers have a utility function in which the amount of salary, status,
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position, power, prestige, security of job, etc., are the most important variables whereas,
owners are more concerned about the size of output, volume of profits, market share, sales
maximisation, etc.
Utility function of the owners and that of the managers are expressed in the following manner
Uo = f [size of output, market share, volume of profit, capital, public esteem etc.] Um = f
[salaries, power, status, prestige, job security, etc.]
Where, Uo is the utility function of owner and Um is the utility function of managers.
Marris notes that the realisation of these two functions would depend on the size of the firm.
Larger the firm, greater would be the realisation of these functions and vice-versa. Size of the
firm, according to Marris, depends on the amount of corporate capital, which includes total
volume of assets, inventory levels, cash reserves, etc. He further points out that managers
always aim at maximising the rate of growth of the firm rather than maximising the growth in
absolute size of the firm. Generally, managers like to stay in a growing firm. A higher growth
rate of the firm satisfies the promotional opportunities of managers and also the shareholders,
as they earn more dividends.
Marris identifies two constraints in the rate of growth of a firm as follows:
1. There is a limit up to which the output of a firm can be increased more economically, limit
to manage the firm efficiently, limit to employ highly qualified and experienced managers,
limit to research, development and innovation, etc.
2. The ambition of job security puts a limit to the growth rate of the firm itself, deliberately. If
growth reaches the maximum, then there would be no opportunity to expand further and
then the managers may lose their jobs. Rapid growth and financial soundness should go
together. Managers hesitate to take unwanted risks and uncertainties in the organisation
at the cost of their jobs. They would like to avoid risky investment projects, concentrate on
generating more internal funds and invest more resources on only those products and
services which bring more profits. Hence, managers would like to ensure their job security
through adoption of a cautious and prudent financial policy.
He further points out that a high risk-loving management would like to maintain a relatively
low amount of cash on hand and invest more on business, borrow more external funds and
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invest more in business expansion and, keep low profit levels. On the other hand, a highly risk-
averse management may have an exactly opposite policy. Ultimately, it is the job security
which puts a constraint on business decisions by the managers.
The Marris’ growth maximisation model highlights the achievement of a balanced growth rate
of a firm. Maximum growth rate [g] is equal to two important variables:
1. The rate of demand for the products [gd]
2. Growth rate of capital[gc] Hence, Max g = gd = gc.
The growth rate of the firm depends on two factors- a] the rate of diversification and b] the
average profit margin.
The diversification rate depends on the number of new products introduced per unit of time
and the rate of success of new products in the market. The success of new products is
determined by changes in fashion, consumption habits, the range of products offered, etc.
Moreover, diminishing marginal returns would operate in any business and thereafter, there is
a limit to diversification. Similarly, market price of the given product, availability of alternative
substitute products and their relative prices, publicity, propaganda and advertisements, R&D
expenses, utility and comparative value of the product, etc. would decide the profit ratio.
Higher expenditure on sales promotion and R&D would certainly reduce profits level as there
are limits to them.
The rate of capital growth is determined by either issue of new shares to obtain additional
funds and external funds and generation of more internal surplus. Generally, a firm would
select the last one to avoid higher degrees of risks in the business.
The Marris’ model states that in order to maximise balanced growth rate or reach equilibrium
position, there should be equality between the growth rate in demand for the products and
growth rate in supply of capital. This implies the satisfaction of the following three conditions:
1. The management has to maintain a low liquidity ratio, i.e., liquid asset / total assets. But,
this ratio should not create any financial embarrassment to meet the required payments to
all the concerned parties.
2. The management has to maintain a proper leverage ratio between value of debts / total
assets, so that it will have enough money to invest in order to stimulate growth.
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3. The management has to keep a high level of retained profits for further expansion and
Retained Profits
development, but it should not displease the shareholders i.e.
Total Profits
by giving low dividends.
In this case, the managers would maximise their utility function and the owners would
maximise their utility functions. The managers are able to get their job security with a high rate
of growth of the firm and shareholders would be satisfied as they receive higher dividends.
Demerits
There are some demerits of Marris’ growth maximisation model. They are as follows:
1. It is doubtful whether both managers and owners would maximise their utility functions
simultaneously, always.
2. The assumption of constant price and production costs are not correct.
3. It is difficult to achieve both growth maximisation and profit maximisation together.
Thus, Marris’ growth maximisation model also has some drawbacks.
5. Baumol’s Static and Dynamic Models

In this section, we will discuss the static and the dynamic models by Prof. W. J. Baumol. Sales
maximisation model is an alternative model for profit maximisation. This model is developed
by Prof. W. J. Baumol, an American economist. This alternative goal has assumed greater
significance in the context of the growth of Oligopolistic firms. The model highlights that the
primary objective of a firm is to maximise its sales rather than to maximise its profits. It states
that the goal of the firm is maximisation of sales revenue subject to a minimum profit
constraint. The minimum profit constraint is determined by the expectations of the
shareholders. This is because no company can displease the shareholders. Here, it is to be
noted that maximisation of sales does not mean maximisation of physical sales but
maximisation of total sales revenue. Hence, the managers are more interested in maximising
sales rather than profit. The basic philosophy is that, when sales are maximised, profits of the
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company would also go up. Hence, in recent years, in the context of highly competitive
markets, attention is diverted towards increasing the sales of the company.
In defence of this model, the following arguments are given:
1. Increase in sales and expansion in its market share is a sign of healthy growth of a normal
company.
2. It increases the competitive ability of the firm and enhances its influence in the market.
3. The amount of slack earnings and salaries of the top managers are directly linked to it.
4. It helps in enhancing the prestige and reputation of top management, in distributing more
dividends to shareholders and in increasing the wages of workers to keep them satisfied.
5. The financial and other lending institutions always keep a watch on the sales revenues of a
firm, as it is an indicator of financial health of a firm.
6. It helps the managers to pursue a policy of steady performance with satisfactory levels of
profits rather than spectacular profit maximisation over a period of time. Managers are
reluctant to take up those kinds of projects which yield high level of profits while having a
high degree of risk and uncertainty. The risk-averse managers prefer to select those
projects which ensure steady and satisfactory levels of profits.
Prof. Baumol has developed two models. The first is the static model and the second one is the
dynamic model.
The static model
This model is based on the following assumptions:
1. The model is applicable to a particular time period
2. The firm aims at maximising its sales revenue subject to a minimum profit constraint.
3. The demand curve of the firm slopes downwards from left to right.
4. The average cost curve of the firm is U-shaped.
With the help of the figure 3, we can explain sales maximisation model subject to a minimum
profit constraint.
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Fig. 3: Sales Maximisation Model

At OX1 level of output, when profit is at maximum, TR is much in excess of TC. If the firm
chooses to produce OX3 output, profit will fall to X3K though the TR is still in excess of TC.
Profit constraint is less at OX2 level of output as the firm earns X2N profit. Depending upon the
market conditions, a firm can determine the level of output with minimum profit constraint.
Sales maximisation [dynamic model]

In the real world, many changes take place which affect business decisions of a firm. In order
to include such changes, Baumol has developed another model, the dynamic model. This
model explains how changes in advertisement expenditure, a major determinant of demand,
would affect the sales revenue of a firm under severe competition.
Assumptions
There are some assumptions in Baumol’s dynamic model. They are as follows:
1. Higher advertisement expenditure would certainly increase sales revenue of a firm.
2. Market price remains constant.
3. Demand and cost curves of the firm are conventional in nature.
Generally, under competitive conditions, a firm in order to increase its volume of sales and
sales revenue would go for aggressive advertising. This leads to a shift in the demand curve to
21
the right. Forward shift in demand curve implies increased advertising expenditure resulting in
higher sales and sales revenue. A price cut may increase sales in general but increase in sales
mainly depends on whether the demand for a product is price-elastic or price-inelastic. A price
reduction policy may increase its sales only when the demand is elastic and if the demand is
inelastic; such a policy would have adverse effects on sales. Hence, to promote sales,
advertisements have become an effective instrument today. It is the experience of most of the
firms that with an increase in advertisement expenditure, sales of the company would also go
up. A firm that maximises sales would generally incur higher amounts of advertisement
expenditure than a firm that maximises profit. However, it is to be remembered that the
amount allotted for sales promotion should bring more-than-proportionate increase in sales
and total profits of a firm. Otherwise, it will have a negative effect on business decisions.
Thus, by introducing a non-price variable into his model, Baumol makes a successful attempt to
analyse the behaviour of a competitive firm under oligopoly market conditions. Under
oligopoly conditions, as there are only a few big firms competing with each other, producing
either similar or differentiated products, the firms would resort to extensive advertising as an
effective means to increase their sales and sales revenue. This appears to be more practical in
the present-day situation.
6. Williamson’s Managerial Discretionary Theory

In this section, we will discuss the managerial discretionary theory by Prof.
O. Williamson. He has developed a highly useful and most practical managerial utility model to
explain goals of a business firm in recent years. In many organisations, we can see that when a
firm achieves a certain amount of growth, the top managers concentrate their attention on
maximising their self-interest and allow the growth rate to continue. Thus, profit maximisation
and managers’ utility maximisation go together.
Assumptions of the model
The managerial discretionary theory is based on the following assumptions:
1. Existence of imperfect markets
2. Ownership and management are separated
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3. A minimum level of profit is to be achieved by a firm to pay dividends to shareholders

Now, let us discuss the model in detail.
The model
Williamson is of the opinion that managers, as a powerful group in any organisation, have their
own set of utility functions. They have certain expectations and demands. Generally, they aim
at maximising their managerial utility function rather than maximising total profits of the
company. They feel that a firm is making profits on account of the efforts of top management
and so they are entitled to certain special privileges and are eligible to enjoy special benefits.
The various kinds of managerial satisfaction include the degree of freedom and autonomy
given to them, their status, prestige, power enjoyed by them, dominance, professional
excellence, security of their jobs, salary and other perquisites, etc. Out of these variables, only
salary is measurable, and all other variables are non- measurable. In order to measure other
variables, Williamson introduces the concept of “expense preference”. This concept helps to
measure the level of satisfaction which managers would derive from certain types of
expenditures. The managers’ utility function is expressed as U = f [S, M, Id], where
S = Additional expenditure of staff M = Managerial Emoluments
Id = Discretionary investment
The additional staff expenditure [S] includes the wages and salaries paid to the additional staff-
members, who have been employed to work under the top management. Now, managers will
have a larger team than before and can allot the work to new staff as a firm expands. The
managers now enjoy more powers to control their subordinates. Higher wages or salaries are
paid in accordance with their productive ability and professional excellence which certainly
would motivate the workers to work more.
Managerial emoluments [M] include expenses on entertainment, luxurious air-conditioned
office, costly company cars and other allowances given to managers. It has been pointed out
that these expenses are justified by managers as it would enhance their status, prestige,
power, better working environment and image of the company in the eyes of public, etc. This
would motivate the managers to do their work in a congenial atmosphere and free manner.
23
Discretionary power of investment expenditure {Id] includes those investment expenses which
confer certain personal benefits and satisfaction to managers, for example, expenditure on
latest equipment, furniture, decoration materials, etc. These expenses are expected to elevate
the status and esteem of managers. They satisfy their ego and sense of pride.
Thus, all these expenditures are made by a firm to keep the managers happy and motivate
them to work more. The above-mentioned expenditures are measurable in terms of money
and they can be used as proxy variables to replace the non-operational concepts like power,
status, prestige, professional excellence, etc. appearing in the managerial utility function.
It is to be noted that all the expenses are included in total cost of operations of a firm. The
profits of the company are measured by taking into account the total expenses and total
revenue earned by a firm. The difference between the TR and TC would measure the volume
of profits. A minimum amount of profits is required to distribute reasonable dividends to
shareholders. Otherwise, they demand a change in management. This would create job
insecurity to the managers. Hence, they can maximise their utility functions only when they
ensure reasonable profits to a company.
There is no direct relationship between managers’ utility function and better performance,
always. The empirical evidence is not enough for the verification of the theory. Always, a firm
cannot spend more money on only improvements in the working conditions of managers. It
has to look into the interests of all groups in an organisation.
7. Summary
Here is a quick recap of what we have learnt so far:
• This unit provided a brief description of the various alternative objectives of a firm. The
traditional objective is that of profit maximisation. But in recent years, economists have
developed various alternative objectives to suit the modern business environment.
• The theory of the firm highlights wealth-maximisation or creation of maximum assets
through which it can generate economic surpluses. The profit maximisation theory stresses
on earning maximum amount of profits by a firm.
24
• Cyert and March theory concentrates on the behaviour of various coalition partners in an
organisation and explain how opposite goals of different groups would affect the decision
making of a firm.
• Marris model analyses the rate of growth of a firm by maximising managers’ powers and
status.
• Baumol analyses the impact of advertisement expenditures incurred by a firm on sales
promotion and its impact on total sales revenue of a firm. Williamson studies the impact of
managerial utility functions on the performance of a firm.
• Thus, a firm has several alternative goals and the selection of particular goals depends on
the management of a firm. It is to be remembered that all other objectives of a firm can be
realised only when a firm is making reasonable amount of profits. Any organisation has to
earn adequate profits to please the shareholders.
• In order to earn more profits, a firm has to create more wealth, assets and surpluses, and
satisfy the expectations of top managers, workers, while achieving a high growth rate of
the firm. All objectives are interconnected and supplement one another. Realisation of one
objective would depend on other objectives. Hence, there should be a proper balance
between different objectives.
8. Glossary
Ballpark data An approximation made with a degree of knowledge and confidence
that the estimated figure falls within a reasonable range of values.
Baumol’s static and The primary objective of a firm is to maximise its sales rather than to
dynamic models maximise its profits.
Economist theory A traditional firm is a group with a particular organisational and
of the firm management structure having command over its own property
rights.
Profit-maximisation Earning highest possible amount of profit during a given period of
time.
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Segment: Pricing in Mass Markets

Topic: Objectives of Firms

1. Profit Maximisation Model ..................................................................................................... 5

Case Let (Continued from segment 2)

1. Profit maximisation model

Let us study some of the important theories under each category.

At the end of this topic, you will be able to:

1. Profit Maximisation Model

Fig. 1: Cost/Revenue Curve: “MR = MC”

Fig.2: Cost/Revenue Curve: “MC Intersecting MR from Below”

2. Economist Theory of the Firm

3. Cyert and March’s Behaviour Theory

4. Marris’ Growth Maximisation Model

5. Baumol’s Static and Dynamic Models

Fig. 3: Sales Maximisation Model

Sales maximisation [dynamic model]

6. Williamson’s Managerial Discretionary Theory

3. A minimum level of profit is to be achieved by a firm to pay dividends to shareholders

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