Maximum Maximization: Takeovers and Profit Maxing

How takeover threats makes even monopolists put profit first

Close your eyes and visualize textbook perfect competition.

In the short-run, Price=Marginal Cost.

In the long-run, Price=Marginal Cost=Average Cost.

Now look in a mirror speak to yourself like Gollum: “Perfect competition. So bright... so beautiful... ahh, precious...”

Then ask yourself a little question in the same creepy voice: “What happens if a perfectly competitive firm fails to maximize profits?”

The textbook answer, as you may recall, is that the firm suffers losses in the short-run, and goes bankrupt in the long-run. Under perfect competition, profit-maximization isn’t just one possible managerial motivation. It is the sole sustainable managerial motivation, because no one is rich enough to lose money forever.

Does the same hold for monopoly as well? No. A monopoly, as long as P⩾AC, can stay in business indefinitely.

Optimistically, this allows a monopolist to safely charge lower prices. Within limits, you can run your monopoly as a charity.

Pessimistically, this allows a monopolist to safely waste inputs. Within limits, you can run your monopoly as a circus.

Unless… your monopoly is publicly traded and hostile takeovers are fully legal. In this scenario, the CEO’s failure to maximize profits won’t bankrupt his company, but it will get the CEO fired.

The mechanism is straightforward. Suppose your monopoly earns $50M annually. The interest rate is 5%, so your company is worth $1B total. The catch: If you maximize profits, the company will earn $100M. The first person who figures this out can simply buy 50.1% of the stock for $501M, fire the lackluster CEO, and replace him with someone who will maximize profits. The value of the raider’s shares skyrockets to $1.002B. If the raider buys up 100% of the stock, he does even better, netting a profit of $1B.

Notice: This only works if firms are publicly traded. Unless I’m actually losing money, I can mismanage my sole proprietorship forever. Furthermore, it only works as long as hostile takeovers are unregulated. If I need the incumbent managers’ permission to buy their company, it might as well be a sole proprietorship. Sure, it is in their self-interest to sell, but their wiggle room is as expansive as their excess profits.

Still, as long as we meet these two conditions - the company is publicly traded and hostile takeovers are unregulated - the results generalize broadly. They hold for every market structure where entry fails to drive price all the way down to average cost. Duopolies, oligopolies, whatever. Perfectly competitive managers face a choice between profit-maximization and bankruptcy. Other managers face a choice between profit-maximization and termination.

“But hostile takeovers are heavily regulated!” you protest? You’re right. But who’s fault is that? Roughly speaking, the same people who lament that “Big corporations can do whatever they want.” If you dream of a world where top CEOs to run their companies with the same urgency as the humble wheat farmer, stop protecting them from corporate raiders. Raiders are the guardians of capitalist efficiency - the professionals who let even the captains of global industry know, “If you fail to maximize profits, you won’t fail for long.”