Cambridge International as and a level Economics Ebook

Loss minimisation
In some situations fi rms may have a short-term 
objective of minimising losses. Th
is is most likely to 
be where a fi rm is facing serious unexpected external 
threats such as the loss of its best customer or a 
downturn in the economy due to some external shock. 
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Chapter 7: The price system and the microeconomy 

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It can be argued that ethical objectives eat into profi ts. 
Th
is is so. Th
e danger all fi rms face is that consumers 
could react very unfavourably to purchasing products that 
come from unethical sources of supply. Given this risk, the 
cost of promoting corporate social responsibility is oft en a 
small price to pay.
The principal agent problem
In setting the various objectives of fi rms it is assumed 
that those who set these objectives have the authority 
and ability to do so. For example, in order to pursue 
an objective of profi t maximisation, managers must be 
able to determine the price and output. Th
e problem is 
that, in large fi rms especially, there is a divorce between 
management and ownership; shareholders and other 
owners are invariably not in a ‘hands on’ position in the 
fi rm to really know whether the decisions being taken are 
the right ones in relation to stated objectives.
Th
is issue is known as the principal agent problem. 
Th
e ‘principal’ is the owner who hires an ‘agent’ to run a 
business in return for a salary and the usual fringe benefi ts 
and bonuses that go with it. Th
ere is a case of information 
failure since the principal is unable to ensure that the 
appointed agent is taking the necessary decisions to run 
the fi rm in the best interests of owners and shareholders. 
Th
is could mean, for example, that the agent is following 
an objective of satisfi cing when the principal believes he or 
she is implementing a policy of profi t maximisation. Th
e 
risk is that the agent has his or her own agenda, essentially 
ignoring the wishes and best interests of the principal. 
Th
e principal’s intended objective for the fi rm is therefore 
not being implemented and it inevitably leads to friction 
between the two parties. Th
ere have, for example, been 
a number of disputes in the designer fashion business 
where the head of design’s ideas for the business have 
not coincided with those of the company’s board and 
shareholders. Th
ese usually surface when a fi rm is losing 
market share or is receiving critical reviews in the media.