Profit, Prinicipals, and Agents
Even if there were no definitional problems of profit, there still would be a fundamental problem with the assumption that
firms maximize profits. Most firms do not have a single
decision-maker. Instead, they are made up of an assortment
of individuals, each using the firm to attain his own goals.
Managers pursue goals; stockholders pursue goals; blue and
white-collar workers pursue goals; but the firm does
The assumption that firms attempt to maximize profits is
inconsistent with the underlying methodology of
microeconomics, which assumes that all decision-makers are
individuals responding to incentives. Mainstream economists criticize Marxists (those
who follow Karl Marx) for dealing in terms of class actions
without grounding these actions on individuals pursuing
goals. Given that most production takes place in firms that
are large organizations, the assumption that firms attempt
to maximize profits is open to the same criticism that
mainstream economists make against the Marxists. The
assumption that firms maximize profits also needs to be
grounded on individuals pursuing goals.
One attempt to ground the assumption of profit
maximization on individual behavior appeals to the
principal-agent problem. An agent acts on behalf of
another person, called a principal. How can the principal be
sure that the agent acts in the principal's interest? The
principal must give the agent incentives to make what is in the self interest of the agent compatible with the goals of the
principal. The most common way to do this is to tie rewards
Payment on a commission basis is an important way to
solve the principal-agent problem. When one hires a lawyer
to sue on a civil matter, an auctioneer to sell one's
belongings, or a real-estate agent to sell one's house, or
when a movie star hires an agent to seek employment, payment
is done with commissions. The agent who does a good job is paid more than the agent who does a poor job.
Sometimes, the principal can protect himself with a
contract that specifies how the task is to be performed and
what the price will be. The ability to use the courts to
enforce the contract protects the principal. Sometimes, the
principal can protect himself by a threat to take the task
elsewhere. This threat is effective if repeat business is
important to the agent.
The principal-agent problem occurs in several places in
the firm, including in the relationship between legal owners
and hired managers. Stockholders own shares because they
believe that this ownership will increase their wealth.
Managers work for the firm primarily because it provides
them with income needed to buy goods and services, and also
because their positions provide them with prestige and
authority. The threat of a takeover or hostile merger
provides stockholders with their most effective constraint
on managerial action. If managers perform poorly at making
profits, shareholders will sell their shares because they
will not achieve their goal of increasing wealth. The lower
value of the company is an inducement for other management
groups to buy out the company and replace management. If the
new managers can improve performance, they can capture at
least some of the increased value of the firm.
Because we live in a world of interdependence and specialization, situations in which agency problems can occur are common. The case can be made that agency problems are more serious in government than in markets or within firms. Principals using agents in the market or in firms usually can influence the incentives of agents. When government is involved, it is harder for principals to have that influence. Do the incentives that elected officials face encourage them to do what is best for the citizens or to act in ways that are not good for the public? What incentives make government bureaucrats act in the interests of the public rather than against those interests? If the incentives are wrong, how does a citizen change them?
Next we consider the alternative assumption that firms
simply try to survive.
Copyright Robert Schenk