Managerial Economics: Group 7 Assignment 1

Introduction
The modern finance theory operates on the assumption that the only objective of a
business concern should be to maximise shareholders’ wealth. On the other hand, the
Neoclassical economics model, assumes that the main goal for firms is profit
maximisation. Our paper seeks to discuss why it is preferable to state the objective of the
firm in the long run as the maximisation of shareholders’ wealth rather than profit
maximisation.

1. Definition of terms

1.1 Wealth maximization

Wealth maximization is a modern approach on the theories of a firm (Englander &
Kaufman, 2004), which involves latest innovations and improvements in the field of the
business concern. The shareholder wealth maximisation (SWM) principle states that the
immediate operating goal and the ultimate purpose of a public corporation is and should
be to maximise return on equity (Windsor, 2010). The term wealth means shareholder
wealth or the wealth of the owners of a business concern. This objective is a universally
accepted concept in the modern field of business. Wealth maximisation is the ability of a
company to increase the market value of its common stock over time. It is the versatile
goal of the company and useful measure for evaluating the performance of a business
organisation. This will help the firm to increase its market share, attain market leadership
and maintain consumer satisfaction. Wealth maximization is superior to profit
maximization because investors expect a return on their investment as they are the
owners of the business. It is therefore of necessity that the main aim of the business
concern is to improve the value or wealth of the shareholders .Otherwise they may
liquidate their equity and invest in higher order value firms. The value to cost associated
with the business concern is considered. Total value derived from the total cost incurred
for the business operation. It provides extract value of the business concern.
Wilkinson (2005) defines shareholder wealth maximisation as the maximization of the net
present value of every decision made in the firm. Net present value is the difference
between the present value of benefits received from a decision and the present value of
the cost of the decision. A financial action with a positive net present value will maximize
the wealth of the shareholders, while a decision with a negative net present value will
reduce the wealth of the shareholders. Under this goal, a firm will only take those
decisions that result in a positive net present value.

1.2 Profit maximization

Profit maximization is the neoclassical objective of a firm (Anderson & Ross, 2005). The
Theory of the Firm states that firms aim to maximize their profits, which is their only noted
raison d’être (raison d’être-reason for being). The firm aims to maximize profit by choosing
the level of output where the marginal cost equals marginal revenue (Anderson & Ross,
2005). Thus, if an additional unit is produced, it will contribute more to cost than revenue
and will be better-off decreasing the production or if it produces a unit less it will be at a
point where it will contribute more to revenue than to cost and will be better-off increasing
production. The Neo-classical model assumes that firms maximize profits in the short run,

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Managerial Economics: Group 7 Assignment 1

managers are rational and they act independently on the basis of full and relevant
information. Figure 1 below graphically depict the profit maximising level of production.

Figure 1: Profit maximization

Due to the increasing growth and complexity of some corporations, owner management
has become practically impossible. Shareholders have increasingly been contracting
agents to manage their firms for them. This has given rise to the principal and agent
relationship. Principal agent theory is a relationship that’s formed when an asset owner
contracts a manager (agent) to manage those assets on the owner’s behalf. Considering
that both parties to the relationship are utility maximisers, there is good reason to believe
that the agent will not always act in the best interests of the principal. Managers, though
employed by the shareholders serve their interests; they do not in reality serve at the best
interest of the shareholders but maximising their utility. This is referred to as the “Principal
agent problem”. It is the management of this problem and the social pressures that is
exerted on the business that has made profit maximisation superseded by wealth
maximisation.
2. Preference of the wealth maximisation objective
Below are reasons it is preferable to state the objective of the firm in the long run as the
maximisation of shareholders wealth rather than profit maximisation per se;
2.1 Long-termism of the wealth maximisation objective
Wealth maximisation as the objective of the firm enables managers to make long-term
plans. On the other hand, profit maximisation as an objective creates a short-termism
behaviour which is characterised by an excessive focus on short-term results at the
expense of long-term business interests. The long run view of the wealth maximisation
objective encourages the creation of organizational resilience through deliberate actions
of innovation, brand building, research and development (Samuelson & Marks, 2012). In

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the short run, costs on these aspects inhibit profit maximisation, but in the long run these
costs are worthwhile investments that can significantly improve a firm’s productive
capacity and its potential to earn higher and more sustainable profits. Apple Inc., the most
valued counter in the world by market capitalization, has mastered this concept. On the
local scene, Econet has created immense value for its shareholders following this path.
2.2 Alignment with shareholder objectives
Jensen and William (1998) argue that the main objective of any business entity is to
maximise the wealth of its shareholders as they are the actual owners of the company
who have invested their capital given the risk inherent in business. According to this
argument, it is more appropriate to set the long run objective of the firm as the
maximisation of shareholder’s wealth as this will ensure that the overarching goal of the
owners of the firm are met or are at least given priority over other firm objectives. Profit
maximisation as a long run objective is ambiguous and may not necessarily entail wealth
maximisation.
2.3 Cure to the principal-agent problem
It is not obvious that managers being agents will serve the interests of the shareholders.
Information asymmetry has led to managers to be self-opportunistic, engaging in actions
and investment decisions that maximise their own utility. Anderson and Ross (2005)
define profit as the reward of taking risk in business. They also proffer that there is a
positive correlation between risk and the level of return. This implies that, in general, the
higher the risk taken, the higher the return expected by management. Managers can
decide to venture into risky investments in an attempt to maximise returns. This is
particularly common where management remuneration is based on profit reported in a
given period. Risky investments can lead to huge losses and closure of companies.
Under shareholder wealth maximisation, managers take decisions that maximise the net
present value of the shareholders. This approach ensures that by meeting their set
objectives, managers will also be meeting the objective of their principal. In the end the
actions of managers will both maximise their utility and the utility of their principals, the
shareholders. Wilkinson (2005) stated that in order to align the goals of the managers
and shareholders, most corporates are now rewarding managers based on the value they
create for shareholders.

2.4 Consideration of the time value of money

Samuelson (2012) argued that wealth maximisation is a preferable objective in the long-
run than profit maximisation because it considers the time value of money. Unlike the
profit maximisation model, the wealth maximisation model considers the time value of
future cash flows in the decision-making process.
2.5 Consideration of societal interests
Modern firms prefer wealth maximisation to profit maximisation as it provides efficient
allocation of resources thereby ensuring the economic interests of the society are met
(Khandwalla, 2004). The modern business environment now rewards good corporate
citizenship which can be satisfied through shareholders' wealth maximisation as firms
seek to build their goodwill.

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Managerial Economics: Group 7 Assignment 1

Conversely, profit maximisation can lead to the exploitation of labour, natural

endowments and consumers. This is usually the case for firms with a monopolistic
position. Monopolies can make maximum profits in the short-run by exploiting their market
position as shown in the diagram below. Abuse of monopoly power could involve setting
excessively high prices or limiting output. Abuse of monopoly power can lead to
deadweight welfare loss, less choice, and problems for suppliers. However, abuse of
monopoly power can attract penalties and revocation of operating licences which would
reduce profit in the future periods (Howard Davies and Pun-Lee Lam, 2001)
The diagram below shows how monopolies maximise their profits in the short-run.

In this diagram, the monopoly raises price from Pc to Pm – leading to a fall in output from
Qc to Qm.
2.6 Broadness of the wealth maximisation concept
Samuelson (2012) stated that profit is a function of wealth. This implies that wealth
maximisation is a broader concept than profit maximisation. In the long-run an entity can
alter all factors of production making it is possible to broaden its objectives from profit
maximisation to wealth maximisation. Profits can be maximised in the short-run by
improving productivity of fixed factors of production, little can be done to maximise wealth
creation under the same circumstances.
2.7 Objectivity the wealth maximisation concept
Profit, whether economic or accounting, is a subjective measure; wealth is not (Goldwater
and Jonath, 2017). Shareholders wealth can be simply calculated by multiplying the
number of shares issued by their market price on a particular day. Both figures are factual
and readily available. On the other hand, profit calculation involves subjective items such
as depreciation and impairment. The calculation of economic profit also involves
opportunity cost which can be difficult to measure apart from being vague. Profit can be

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manipulated easily usually in an attempt to present more favourable results. For example,
a change in an accounting assumption or policy can result in a change in profit. Since
management is responsible for the preparation of financial reports and formulation of
accounting policies, they can easily find their way in manipulating profit figures. Window-
dressing related scandals are generally on the rise with some international companies,
such as JPMorgan and Toshiba, having been implicated in such cases. On the other
hand, the wealth maximization concept is based on cash flows and not on profits. Unlike
profits, cash flows are exact and definite and therefore avoid any ambiguity associated
with profits.

2.8 Consideration of risk

Shareholder wealth maximization recognises the risk associated with each particular
investment using the discount rate as a measure of risk. An investment with a higher
discount rate is less attractive than an investment with a lower discount rate, ceteris
paribus. Under shareholder wealth maximisation, risk consideration is an integral part of
investment appraisal. The discount rate is used to calculate the present value of future
cashflows. The discount rate is also a measure of the opportunity cost associated with
each particular investment.
3. Criticism of the profit maximization model
The profit maximization model is built on assumptions, which do not hold water in the
modern world and has dealt a great blow of unpopularity as the primary goal of a modern
firm
3.1 The firm has a single decision-maker
This assumed that the firm is owner managed and the owner is the alpha and omega of
all decisions. It is no longer a tenable assumption since in any firm even the small to
medium enterprises now delegate and empower their employees to make decisions on
their behalf as they see fit in the best interest of the business. Decisions of different
importance and relating to different functional areas are taken by different managers and
other employees, while the board of directors and shareholders still make some of the
most important decisions. This leads to an agency nexus that does not maximise profit.
3.2 The firm produces for a single market
A market does not necessarily have to involve a physical location; the Internet provides
a market, as does NASDAQ Stock Market and similar stock exchange systems (Wilkinson
N). However, businessmen and managers often are referring only to buyers or potential
buyers when they use the term market. It is this sense that is meant in the assumption of
a single market. Thus a single market means a homogeneous group of customers. In
contemporary business world, firms are serving diversified markets that are sustainable
and provide stable shareholders` wealth growth.
3.3 The firm produces and sells in a single location
While the meaning of producing and selling in a single location is clear, it is equally clear
that contemporary firms produce in many different countries and locations and sell in
many different countries. Firms have become global citizens taking advantage of
variations in costs, legislations and revenues to set up shop in locations that enhance
shareholder value.

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3.4 All current and future costs and revenues are known with certainty
Full and perfect knowledge is assumed about the past performance, the present
conditions and future developments in the environment of the firm. The firm knows with
certainty its own demand and cost functions. It learns from past mistakes, in that its
experience is incorporated into its continuous appraisal (estimation) of its demand and
costs. The costs are U-shaped both in the short and in the long run, implying a single
optimum level of output. The assumption expects a well-managed firm to have accurate,
detailed and up-to-date records of its current costs and revenues but the business and
economic environment have become volatile and complex and cost and revenue of the
future are impossible to know with certainty hence shareholder wealth maximisation is
preferred. Even if there is reliance on the on historical data it will still be difficult to estimate
reliably what these will be in future, next year, next quarter or sometimes even a week
(Wilkinson N, 2001). Therefore, this uncertainty has made firms to shift to maximisation
of wealth.
3.5 Price is the most important variable in the marketing mix
Businesses in the modern world are not price takers and they have an array of stochastic
variables in the marketing mix available to them with some having superior importance to
price. In the case of luxury goods for instance, quality is of high regards for the niche
market does not have problems in paying but have problems in accepting products or
services of compromised quality. However, in pursuit of wealth maximisation, firms on a
day-to-day level strive to maximise profit as well. In as much as wealth maximisation has
received prominence, profit maximisation remains vital as it ensures business continuity
and provides good news which if the market is efficient would lead to an appreciation of
a firm`s share price hence shareholders` wealth increases also.
In the final analysis, modern firms are indeed concerned with the maximisation of
shareholder wealth rather than profit maximisation. The reasons are that there is need for
calculated strategies to safeguard against risks and uncertainty in the long run of the firm,
need for investments which are worth more than profits that are for short term and
considerations of the societal interest.
4. Conclusion
Therefore it can be concluded that most firms are concerned with wealth maximisation
rather than profit maximisation due to the long-term benefits that wealth maximisation
brings to the sustainability of the business concern. The arguments for wealth
maximisation and limitations of profit maximisation have been discussed to justify why
modern firms are concerned with the maximisation of shareholders wealth.

References

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Managerial Economics: Group 7 Assignment 1

Anderson, W. L., & Ross, R. L. (2005). "The Methodology of Profit Maximization: An

Austrian Alternative.". The Quarterly Journal of Austrian Economics, 31-44.
Baye, M. R. (2010). Managerial Economics and Business Strategy. Indiana: McGraw Hill.
Englander, E., & Kaufman, A. (2004). The end of managerial ideology: From corporate
social responsibility to corporate social indifference. The Business History Conference
(pp. 404–450). Le Creusot: The Business History Conference.
Khandwalla, P. N. (2004). Management Paradigms Beyond Profit Maximization. Vikalpa:
The Journal for Decision Makers, 97-116.
Samuelson, W. F., & G, M. S. (2012). Managerial Economics. New Baskervill: John Wiley
& Sons Inc.
Wilkinson, N. (2005). Managerial Economics: A problem solving approach. Cambridge:
Cambridge University Press.
Windsor, D. (2010). Shareholder Wealth Maximization. In J. R. Boatright, Finance ethics:
Critical issues in theory, practice (pp. 437-452). Hoboken, New Jersey: Wiley.
Howard Davies and Pun-Lee Lam (2001). Managerial Economics: An analysis of
Business Issues, Prentice Hall, page 16