Maximizing a sole proprietor’s utility is equivalent to maximizing his or her economic profit, but only after weighing all psychic benefits and costs, including losses of leisure. Do corporate managers necessarily try to maximize stockholders’ profits? Executives are, after all, people who can be expected to maximize their own interests.
Separation of Ownership and Control
Some economists contend that unless most stockholders become restless, managers pursue goals other than maximum profits. Bookkeeping practices that are not identical between firms sometimes obscure comparisons. What evidence can managers offer that stockholders’ gains are being maximized? Stock prices reflect expectations about a firm’s profits. But accounting profits in annual reports (corporate documents that legally must be published each year) seldom conform closely to a firm’s economic profits.
Just as taxpayers try to maximize take-home pay by taking every possible deduction to minimize taxable income, some bookkeeping practices reduce accounting profit while increasing after-tax economic profits. For example, if an accountant uses a schedule established by the Internal Revenue Service that sets depreciation allowances (a tax-deductible cost) in excess of actual depreciation, a firm’s taxes on income are reduced or delayed, increasing its economic profit. But the lower taxable income reported in the firm’s annual report may alarm stockholders. If the bottom line on annual reports is sometimes misleading, how can chief executive officers (CEOs) signal their competence to stockholders?
The Principal–Agent Problem
Firms face major obstacles when coordinating the productive efforts of groups of employees with disparate goals and objectives. Specialization and the complexity of everyday life lead to countless situations where one party, a principal, contracts with another, an agent, in expectation that the agent will serve the principal’s interest.
Large firms operate primarily through agents, which include most of their employees. Pay incentives are one aspect of contracts by which people try to alter the behavior of others. Some contracts between principals and agents are verbal and informal. You are a principal, for example, if a friend agrees to fill your gas tank if she can keep the change from the $20 you hand her. Her agreement makes her your agent.
The principal–agent problem arises when the agent pursues personal goals that conflict with the principal’s contractual rights.
Your friend, for example, might keep more change from the $20 by not completely filling your tank, or she might buy cheap gas after you specified premium unleaded.
Conflicts between the legal rights of a firm (the principal) and the goals of its employees (one group of its agents) can cause inefficiency. A firm’s costs will be inefficiently high if, for example, it hires a purchasing agent who solicits bribes from suppliers who then sell intermediate goods to the firm at inflated prices. Consequently, monitoring resource suppliers’ performance is a major task in coordinating production.
Principal–agent problems may arise when maximizing a firm’s profit conflicts with the self-interests of business decision-makers. For example, the desires of business executives for such things as plusher offices, longer vacations, first-class travel, sycophantic subordinates, or higher personal salaries clearly raise costs and shrink profits.
Just as most people would rather get goods free than pay for them, many workers want to minimize their effort but still be paid. The principal–agent problem of shirking occurs when workers fail to perform properly. Shirking occurs, for example, if a security guard naps during a night shift, or when a professional athlete with a guaranteed contract reports to training camp flabby and poorly conditioned. Shirking also occurs if, say, a raw materials supplier tries to charge for more than it delivers.
An employer can avoid possible principal–agent shirking problems by directly supervising employees. But supervision is often difficult and costly. This is why many employers have adopted incentive compensation systems such as stock options for executives, commissions and bonuses for sales people, and incentive-based performance contracts for multiyear, multimillion dollar professional athletes. In addition to these problems, firms face complex competitive pressures from the marketplace.
Market Pressures and Evolution
Economists typically find the profit maximization goal persuasive because competition for lucrative managerial slots pressures top managers to try to maximize profits. Most economists also reject the idea that accounting information systematically misleads stockholders. Some people might be fooled, but the enormous profits at stake cause experts to scrutinize annual reports so that corporate information is efficiently processed.
Nevertheless, mistakes are fairly common. Many executives survive despite gaffes that cost their firms enormous profits. For example, critics charge that Ross Johnson, the CEO of RJR Nabisco (the result of the largest merger in history), wasted tremendous amounts of funds on his personal comfort and generally mismanaged the firm’s assets. On the other hand, managers often forgo options that would generate solid profits. For example, dozens of publishers turned down the opportunity to publish In Search of Excellence, by Tom Peters and Robert H. Waterman, Jr. The book ultimately sold millions of copies.
A key to success as an executive is to be relatively more efficient (or less inefficient) than your competitors. Bankruptcy of the firm or stockholder revolts occasionally dislodge top managers who consistently fail to maximize their firm’s profits, but the most powerful pressures for efficiency in corporate giants probably emerge from the market for corporate control. A firm that does not perform at least as well as average at maximizing profit will have assets that are worth more than the total value of the corporation’s stock. Such firms are natural targets for hostile takeovers, the acquisition of one firm by a group of owners and managers who think they can do a better job.
John Kenneth Galbraith is one critic who rejects economic theories that stress competitive markets and the goal of profit maximization. Galbraith argues that giant corporations (a) dominate economic activity because small competitive firms cannot afford the modern technologies required for efficient economies of scale and scope, (b) are controlled by corporate managers who seek maximum power and pay for themselves instead of maximum profits for stockholders, (c) tend to corrupt government policies to help consolidate managerial power and achieve managers’ goals rather than the public interest, and (d) use extensive advertising to avoid meaningful competition.
What evidence supports Galbraith’s claims? First, corporations do account for a dominate share of U.S. business revenues and control large shares of our national resources. There is an erratic long-term trend towards even greater concentration in the ownership of total manufacturing assets, which contributes to corporate giantism. Some giant firms substantially exceed the sizes of the governments of medium-sized countries. According to Galbraith, our only hope for a just society is for modern corporate managers to become more socially responsible, but he is somewhat pessimistic about the prospects for such changes of heart.
A competitive market system rewards those who serve consumers and society, while forcing inefficient firms to adapt or exit the market. Many firms vie for consumers’ patronage in competitive markets. Will society derive the same benefits if a few firms dominate a market? Most people think not. Modern economic life often seems far removed from competitive models of the economy. There is, however, evidence that markets serve consumers reasonably well and that size alone does not insulate firms from competitive pressures. Giants compete with giants.
Such once dominant retailers as Sears, Montgomery Ward, and J. C. Penney have lost ground to firms like Wal-Mart, Venture, and Target. And what happened to the giant railroads of a century ago? Most disappeared or were absorbed into Amtrak, a government-subsidized money loser.
After Ford Motor Company lost millions of dollars when it launched the ill-fated Edsel in the 1950s, it more than recouped these losses when it developed the Mustang and Explorer, cars that passed the market test. A shaky economy and competition from foreign automakers imposed billions of dollars in losses on U.S. automakers in the late 1970s. Chrysler teetered on the brink of bankruptcy but recovered when Henry Ford II fired Lee Iacocca, the father of the Mustang, and he became the chief executive officer at Chrysler. He immediately authorized $500 million in development funding for the minivan introduced in the mid 1980s. Today, Chrysler is profitable and sells nearly half of all new minivans bought in America. All automakers recovered in the late 1980s when they marketed more fuel efficient and reliable cars.
Interindustry competition has become increasingly important. Xerox once had a near monopoly on copying equipment but now competes with IBM and a host of Japanese firms. IBM had a stranglehold on the computer market in the 1960s, but now must compete with Dell, Gateway, Hewlett-Packard, Apple, Radio Shack, Control Data, NEC, DEC, Xerox. AT&T, and hundreds of small electronics firms. Today, the market value of the software giant, Microsoft, exceeds that of IBM. Interestingly, Microsoft’s principle asset (its computer program code) is intellectual property and Microsoft does not own any manufacturing facilities of any consequence.
Giants often emerge from nowhere when entrepreneurs perceive a void in the marketplace or a better way to organize their operations. Steve Jobs, a 17-year-old high school student, and Steve Wozniak, a 22-year-old college dropout, launched Apple Computers from their garage in 1978 for under $500, creating a billion-dollar firm within four years after they marketed the first low-cost personal computer. It is hard to overstate how risky business can be. A boom in personal computer sales and software in the early 1980s made overnight millionaires of hundreds of young programmer workaholics in the Silicon Valley, an area just south of San Francisco. Gluts on the market quickly appeared, however, and hundreds of firms collapsed during the late 1980s as consumers demanded more sophisticated software. Today’s integrated software is designed, programmed, and tested by huge teams employed by large software firms. Most of the small entrepreneurial effort is devoted to shareware (i.e., programs distributed from bulletin boards to users who pay small registration fees if they find the programs useful).
The key point is that high profits attract aggressive competition, both foreign and domestic, so consumers’ needs are met in a reasonably efficient fashion. Many people remain unhappy with market outcomes, however, and increasingly turn to government to resolve economic problems. Health-care reform is just one recent example. Income distributions that result from the market system are often perceived as unfair. And what about national defense or such problems as pollution and excessive unemployment? We will explore these and similar questions later in the book when we examine areas in which government plays an active role in our society.
Underpinnings for consumer demands were discussed in the previous chapter, but supply has been addressed only intuitively. In the next chapter, we explore how production relationships link inputs and outputs to determine costs and shape managerial decisions about how much to produce and which technology to use. Then, in the next few chapters, we investigate how competition for consumers’ dollars differs in intensity across industries and interacts with production costs to determine prices, output, and consumer purchases.