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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 not.

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 with performance.

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.

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Copyright Robert Schenk