The Assumption Of Profit Maximization

From the preceding discussion, it might seem that the profit-maximizing assumption underlying most of this chapter is somewhat naive. After all, because of the principal-agent problem, the firm may not always maximize profits, even though that is what the owners want. Why, then, did we base our theory of firm behavior on such a simple assumption? Why not go back and view the firm in light of the principal-agent problem?

For one very good reason: The assumption of profit maximization, while not completely accurate, is reasonably accurate in most cases. While profit maximization is not the only goal of decision makers at the firm, it seems to be the driving force behind most management decisions. Remember that an economic model abstracts from reality. To stay simple and comprehensible, it leaves out many real-world details and includes only what is relevant for the purpose at hand. If the purpose is to explain conflict within the firm, or deviations from profit-maximizing behavior, the principal-agent problem would be a central element of the model. But when the purpose is to explain how firms decide what price to charge and how much to produce, how much to spend on advertising, or whether to shut down or continue operating in the short run, the assumption of profit maximization has proven to be sufficient. It explains what firms actually do with reasonable—and often remarkable—accuracy.

Even in larger firms, profit maximization seems to be the most important force driving firm decisions. How can this be, when principal-agent problems can be so serious in large firms? In part, because the market provides some solutions to the principal-agent problem of large firms. Although far from perfect, they prevent the firm from straying too far from the profit-maximizing course.

For example, if a firm's managers significantly inflate costs and reduce profit, the company's stock will become less attractive to potential buyers, and its price will fall. Management will then face one of two consequences: (1) a stockholder revolt, in which owners, seeing that their firm is less profitable than others in the industry, replace the management team with another that promises to do better, or (2) a hostile takeover, in which outsiders buy up a majority of the firm's shares at low prices, often with the goal of sacking the current managers and replacing them with better ones. (The term hostile is from the viewpoint of the current managers.) In large corporations, poor management decisions can reduce profits by millions or even billions of dollars. Since there is so much at stake, stockholder revolts and hostile takeovers are not at all uncommon.

A recent example of a stockholder revolt occurred at USAir. With negative profits each year from 1990 to 1994, the company was headed toward bankruptcy. Stockholders blamed the management. In January 1996, the airline's board of directors, elected by its shareholders, took the first step toward replacing the manage-

ment team by bringing on Stephen Wolf as the new chief executive. Wolf undertook a series of dramatic actions that included placing a large order for new planes, aggressive cost cutting, and a change of the firm's name to US Airways. Over the next several years, more changes were implemented, profits increased dramatically, and the market value of US Airways stock grew by 1,000 percent.

A hostile takeover is more complicated than a stockholder revolt, because the current managers, who are the likely losers in a hostile takeover, can attempt a variety of measures to foil it. A recent example—and one that illustrates some of the vocabulary you will see in the business pages of your local newspaper—is the case of John Labatt Ltd., the Canadian beer maker. When Labatt's profits dwindled in late

1994 and the price of its stock dropped to 19 Canadian dollars per share, the financial press blamed poor management decisions. Sensing the firm was ripe for a hostile takeover, Labatt's managers tried to forestall it with a variety of actions designed to make the firm less attractive to outsiders, such as selling off valuable assets or taking on especially risky new projects. But at the company's annual shareholder meeting, the shareholders voted to reject these moves. They wanted a takeover so they could sell their shares at a price reflecting the firm's potential profit under new management. Sure enough, the hostile takeover attempt came in early

1995 when an outsider—Onex Corporation—offered to buy all Labatt shares for 24 Canadian dollars each. Labatt's management responded by trying to arrange a friendly takeover by another firm deemed less likely to fire them. The white knight that came to their rescue was Interbrew SA, a Belgian beer maker. Interbrew was eager to expand into Canada to fulfill its own strategic plan, and it made an even more generous offer to Labatt's shareholders—28.5 Canadian dollars per share. In June 1995, Labatt's board of directors, representing the shareholders, happily agreed to the acquisition. A new president was soon put in place, and the firm went on to increase both its domestic market share and its exports to the United States.

The threat of being fired is a powerful incentive for managers to worry about profits, but many firms use positive incentives as well. End-of-year bonuses—payments in addition to regular wages or salary—are often tied to total profit at the firm. In many cases, these bonuses are a substantial portion of a manager's total compensation. Stock options—which give managers the right to buy shares of the company's stock at a prespecified price—are another positive incentive. If the managers perform well, the market value of the firm's stock will rise. The managers can then exercise their stock options—purchasing the stock at the prespecified low price—and, if they choose, they can immediately sell the stock at the higher, market price and pocket the difference.

To see how stock options work, let's use the case of Floyd Hall (no relation to any author of this book). In June 1995, Hall was hired as Kmart corporation's new president. His yearly salary was about $1 million. But he was also given stock options to buy 3 million shares of Kmart stock at the then-current price of $12.38 per share. If he and his management team could increase the company's profits and convince potential stockholders that earnings growth would continue, then Kmart stock would become more attractive, and its price would rise. For example, if the stock rose $20 per share, then Floyd Hall would be able to exercise his options: He could buy 3 million shares at $12.38 each (a total of $37 million), and then immediately sell them at $20 each (a total of $60 million), making a tidy gain of $23 million.

Needless to say, Hall tried to do everything he could to raise Kmart's profits over the next several years. The results were mixed. Profits did grow, but Hall was unable to convince stockholders and potential stockholders that rapid growth in earnings would continue, especially with Kmart facing aggressive competitors like Wal-Mart http://

The Wharton School of the University of Pennsylvania maintains a Web page on corporate governance (http://www-management. wharton.upenn.edu/leadership/ governance/). Click on "Corporate Control" for more information on factors that help discipline corporate managers.

Friendly takeover When a firm's management arranges a takeover by another firm deemed unlikely to fire them.

White knight A firm that undertakes a friendly takeover.

Stock options Rights to purchase shares of stock at a prespecified price.

The Foundation for Enterprise Development (http://www.fed. org/about/index.html). provides information about employee ownership and stock options as means of motivating employees.

and Target. In April 2000, Kmart stock was actually selling at around $9 per share— significantly below the price when Hall had been hired. Hall's stock options were therefore worthless: What would be the point of exercising the right to buy shares at $12.38 when they could be purchased in the market for $9? Nevertheless, since Hall still owned the options, he had a powerful incentive to keep trying. (And if he failed to raise the stock's price, he would probably not retain his position much longer. By the end of 1999, at least two large supermarket chains—Safeway and Kroger—were reportedly eyeing Kmart as a potential takeover candidate.)

Incentives like bonuses and stock options on the one hand and threats of stockholder revolt or hostile takeover on the other are usually enough to keep management's eye on company profits. When this carrot-and-stick approach doesn't work, then actual revolts or takeovers—and the dumping or disciplining of management— ensure that poor managers do not survive for long. At any given time, therefore, we can expect most managers to try to maximize profits most of the time.

Similar mechanisms help ensure that hourly workers contribute to maximum profit at the firm. There are, indeed, plenty of opportunities to shirk or otherwise frustrate management's goals, but these can be pursued only up to a point, or the worker can expect to be fired. Television's Homer Simpson has on numerous occasions spilled coffee into the control panel of the nuclear reactor he operates, stolen expensive equipment for home use, and taken snoozes while the reactor goes into meltdown. Nobody in the real world would survive in a job with his record.

For all of the reasons just discussed, assuming that firms maximize profit for their owners is not too far off the mark. The principal-agent problem does exist, and it helps us understand many aspects of firm behavior, such as conflicts that arise within the firm, the structure of pay, and the methods used to supervise workers and managers. However, if our goal is to achieve a reasonably accurate prediction of firm decisions, profit maximization works pretty well.

Ask a physicist to predict when a bowling ball dropped from the top of the Empire State building will hit the ground, and her calculations will assume it is falling in a perfect vacuum. Ask an economist to predict how much output a firm will produce and what price it will charge, and he will assume the firm's only goal is to maximize profit. In both cases the assumptions lead to very accurate—if not perfectly accurate—predictions.

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