Differing objectives and policies of firms

Differing Objectives and Policies of Firms (9708 A Level Microeconomics)

Hello, future Economists! This chapter is incredibly important because it takes the abstract theories of perfect competition and monopoly and introduces a dose of reality: the people running firms don't always aim solely for maximum profit. Different objectives lead to drastically different business decisions. Understanding these differences allows for much stronger analysis and evaluation in your exams!

1. The Traditional Objective: Profit Maximisation

For many years, traditional economic theory assumed that every firm's single goal was to maximise profit. This is the baseline objective we compare all others against.

What is Profit Maximisation?

A firm maximises its profit by producing the level of output where the difference between TR (Total Revenue) and TC (Total Cost) is greatest.

The key condition for profit maximisation is:

• Marginal Revenue (MR) = Marginal Cost (MC)

This rule means that the firm continues to produce up to the point where the extra revenue earned from the last unit sold (\( \text{MR} \)) is exactly equal to the extra cost of producing that unit (\( \text{MC} \)).

Step-by-Step Logic (The Margin Rule):

1. If \( \text{MR} > \text{MC} \): The last unit sold added more to revenue than it did to cost. The firm should produce more to increase total profit.
2. If \( \text{MR} < \text{MC} \): The last unit sold added more to cost than it did to revenue. The firm should produce less to increase total profit.
3. If \( \text{MR} = \text{MC} \): This is the profit-maximising output level. Total profit is as high as it can be.

Analogy: Imagine you are selling ice cream. If the last scoop you sold brought in \$2 of revenue, but only cost \$1 to make (\( \text{MR} > \text{MC} \)), you should definitely make another scoop! If the next scoop only brought in \$1 but cost \$3 (\( \text{MR} < \text{MC} \))—stop!

2. Other Objectives of Firms

In the real world, especially in large corporations or businesses facing intense competition, other goals often take priority over pure profit maximisation, particularly due to the separation of ownership and control.

2.1 Survival

This objective is often adopted by:

• New firms just entering a highly competitive market.
• Firms operating during an economic recession or crisis (like a pandemic).
• Firms facing immediate threats (e.g., strong rival entry).

The survival objective prioritises maintaining enough cash flow to stay afloat, sometimes even accepting subnormal profit in the short run, as long as they cover their average variable costs (\( \text{AVC} \)).

2.2 Profit Satisficing

This objective arises from the Principal-Agent Problem.

• The Principal (owners/shareholders) wants maximum profit.
• The Agents (managers) run the day-to-day operations and have their own goals (big salary, easy working hours, company perks).

Profit satisficing occurs when managers aim for a target level of profit that is high enough to keep the shareholders happy, but not necessarily the absolute maximum profit possible. This allows managers to pursue their own interests (e.g., investing in unnecessarily luxurious offices or having a shorter workday).

2.3 Revenue Maximisation

The goal here is to achieve the highest possible Total Revenue (TR).

• Condition: Marginal Revenue (MR) = 0 (\( \text{MR} = 0 \)).

If \( \text{MR} \) is zero, selling the next unit would bring in no extra revenue (or negative revenue), meaning \( \text{TR} \) is at its peak.

Why pursue Revenue Maximisation?

• Managerial Rewards: Managers may be rewarded with bonuses linked to turnover or market size, not profit.
• Market Dominance: High revenue often signals large market share and power, which can lead to higher long-run profits later.
• Financial Perception: Banks are often more willing to lend money to firms that show very high turnover.

2.4 Sales Maximisation

This is distinct from Revenue Maximisation. The aim is to maximise the volume of output sold, usually subject to the constraint that the firm must make at least Normal Profit (i.e., \( \text{TR} \ge \text{TC} \)).

• Condition: Typically \( \text{AR} = \text{AC} \) (Average Revenue equals Average Cost), where the firm breaks even, selling the most units possible without making a loss.

Why pursue Sales Maximisation?

• Market Share: Gaining a larger share of the market can provide long-run advantages and discourage new entrants.
• Economies of Scale: High volume output helps firms achieve internal economies of scale, lowering average costs for future production.

3. Pricing Policies of Firms

Once a firm determines its objective (e.g., profit or survival), it must choose a pricing policy to achieve that goal. Pricing is often complex, especially in imperfect markets (like monopoly or oligopoly).

3.1 Price Discrimination

Price discrimination occurs when a firm sells the same good or service to different consumers at different prices, for reasons not associated with differences in costs of production.

Conditions for Effective Price Discrimination:

1. Market Power: The firm must have some degree of monopoly power (a downward sloping demand curve) to set prices.
2. Market Separation: The firm must be able to prevent consumers who buy at a low price from reselling the product to those who are charged a high price (prevent arbitrage, e.g., non-transferable airline tickets).
3. Differing Price Elasticities of Demand (PED): The firm must be able to identify different submarkets with different \( \text{PED} \)s. (It charges higher prices to inelastic submarkets and lower prices to elastic submarkets).

Types (Degrees) of Price Discrimination:

• First Degree (Perfect): Charging each customer the maximum price they are willing to pay. This converts all consumer surplus into producer surplus. Example: Negotiating a bespoke price directly with each client.
• Second Degree: Charging different prices based on the quantity consumed or volume blocks (bulk buying discounts). Example: Utility companies offering tiered block tariffs.
• Third Degree: Dividing consumers into distinct groups (submarkets) based on identifiable characteristics and charging each group a different price. Example: Student/senior citizen discounts, off-peak versus peak travel.

Consequences of Price Discrimination:

• Impact on Consumer Surplus and Producer Surplus: Consumer surplus is reduced and transferred to the firm as supernormal profit (producer surplus). In first-degree price discrimination, consumer surplus is eliminated entirely.
• Output Expansion and Market Access: Total output is often higher than under a single-price monopoly. Lower prices in elastic submarkets allow lower-income consumers (e.g., students, off-peak commuters) to access services they could not otherwise afford.
• Cross-Subsidisation: Supernormal profits earned in inelastic submarkets can be used to subsidise socially beneficial but loss-making services or fund dynamic efficiency investments (R&D).
• Equity and Fairness Concerns: Consumers charged higher prices in inelastic submarkets may feel exploited, worsening distributional equity.

3.2 Other Pricing Policies (Especially relevant in Oligopoly)

Limit Pricing

Limit pricing is setting a low enough price to make it unprofitable for potential new rivals to enter the market. The incumbent firm chooses an output level that prevents the new entrant from earning normal profit.

• This policy often means the existing firm sacrifices maximum short-run profit to ensure long-run survival and market dominance.

Predatory Pricing

Predatory pricing is an aggressive tactic where a dominant firm sets its price below its average cost (AC/AVC) for a sustained period.

• Objective: To drive existing, weaker competitors out of the market entirely.
• Consequence: Once rivals leave, the predator raises prices to monopoly levels, earning supernormal profits. This practice is anti-competitive and illegal in many jurisdictions.

Price Leadership

In an oligopoly (a market dominated by a few large firms), firms often avoid price wars. Instead, one large, dominant firm (the price leader) sets the industry price, and the smaller firms (the price followers) adjust their prices accordingly.

• This allows for tacit collusion (unspoken agreement) and helps maintain price stability in the industry.

4. Revenue and Price Elasticity of Demand (PED)

A crucial tool for firms, especially when implementing policies like revenue maximisation or price discrimination, is understanding the relationship between the price elasticity of demand (\( \text{PED} \)) and Total Revenue (\( \text{TR} \)).

4.1 The Relationship in a Normal Downward Sloping Demand Curve

When a demand curve slopes downwards, different parts of the curve have different \( \text{PED} \) values:

• Elastic Region (\( |\text{PED}| > 1 \)): A fall in price leads to a proportionately larger rise in quantity demanded, so TR increases (\( \text{MR} > 0 \)). Firms wishing to maximise revenue will operate in this range.
• Inelastic Region (\( |\text{PED}| < 1 \)): A fall in price leads to a proportionately smaller rise in quantity demanded, so TR decreases (\( \text{MR} < 0 \)).
• Unit Elastic Point (\( |\text{PED}| = 1 \)): This is the point where Total Revenue is maximised (corresponding to \( \text{MR} = 0 \)).

A profit maximiser (\( \text{MR} = \text{MC} \)) with positive marginal cost will never produce in the inelastic region, because positive \( \text{MC} \) requires positive \( \text{MR} \), which only occurs where demand is elastic. Produce where \( \text{MR} > 0 \).

4.2 The Kinked Demand Curve (Oligopoly)

This concept is highly relevant in understanding pricing in oligopoly markets where firms are interdependent (meaning one firm's action affects the others).

The Kink Hypothesis:

Firms in an oligopoly assume that their rivals will react asymmetric to price changes:

1. If Firm A raises its price: Rivals will ignore the price rise, knowing that Firm A will lose market share. The demand facing Firm A is therefore highly elastic above the current price.
2. If Firm A lowers its price: Rivals will match the price cut immediately to avoid losing their own market share. The demand facing Firm A is therefore highly inelastic below the current price.

This combination creates a "kink" in the demand curve at the current market price.

Implication for Marginal Revenue (MR):

Because the demand curve has a sudden change in slope, the resulting Marginal Revenue (\( \text{MR} \)) curve has a vertical discontinuity (a gap).

• This means that even if costs (\( \text{MC} \)) fluctuate within this gap, the profit-maximising output (where \( \text{MR} = \text{MC} \)) and price remain constant.
• Result: Oligopolies often exhibit significant price stability (rigidity), making price competition uncommon. They tend to rely on non-price competition (e.g., advertising, product differentiation, branding).