Welcome to "Objectives of Firms"!
Hi there! Welcome to one of the most practical chapters in your H2 Economics journey. Have you ever wondered why some companies like Amazon spent years losing money while trying to grow, while your local bakery just seems happy to pay its bills?
In this chapter, we explore the "why" behind business decisions. While the textbook answer is often "to make money," the reality is a bit more interesting. We’ll look at the traditional objective (Profit Maximisation) and the alternative objectives firms might choose instead. Don't worry if this seems a bit abstract right now—we'll break it down step-by-step!
1. The Traditional Goal: Profit Maximisation
In standard economic theory, we assume most firms are rational and want to make as much money as possible. This is called Profit Maximisation.
What is Profit?
Simply put, profit is what you have left after paying all your expenses.
Formula: \( \text{Profit} = \text{Total Revenue (TR)} - \text{Total Cost (TC)} \)
The "Golden Rule" of Profit Maximisation
A firm maximises its profit when it produces at the output level where:
1. \( MR = MC \) (Marginal Revenue equals Marginal Cost)
2. \( MC \) is rising
Wait, what do "Marginal" terms mean?
If you're struggling with "marginal," just think of the word "extra":
- Marginal Revenue (MR): The extra money earned from selling one more unit.
- Marginal Cost (MC): The extra cost of producing one more unit.
The Logic (The "Buffet" Analogy)
Imagine you are at an all-you-can-eat buffet.
- The benefit (MR) is the enjoyment of the extra plate of food.
- The cost (MC) is how uncomfortably full you feel.
Quick Review Box:
- If \( MR > MC \): The firm should produce more (each extra unit adds to total profit).
- If \( MR < MC \): The firm should produce less (the last unit cost more to make than it earned).
- If \( MR = MC \): The firm is at its maximum profit point.
2. Why Firms Might Fail to Maximise Profit
Even if a firm wants to maximise profit, they might not be able to. The syllabus highlights a key reason: Information Failure.
Real-world managers often lack sufficient or accurate information. To hit the \( MR = MC \) point, a manager needs to know exactly what their demand curve looks like (to calculate MR) and exactly what their production costs are (to calculate MC). In a fast-changing world, these numbers change every day, making it very hard to be 100% precise.
Key Takeaway: Profit maximisation is the theoretical "ideal," but lack of data often makes it a "best guess" in reality.
3. Alternative Objectives of Firms
Sometimes, firms choose not to maximise profit on purpose. Here are the three main alternatives you need to know:
A. Revenue Maximisation
Instead of the biggest profit, the firm wants the biggest sales figure (Total Revenue).
Condition: This happens when \( MR = 0 \).
Example: A manager might do this if their yearly bonus is linked to sales targets rather than profit. Or, a firm might do this to gain "prestige" or to scare off competitors by looking massive.
B. Market Share Dominance
This is when a firm wants to control the largest percentage of total sales in the industry. They want to be the "Big Fish" in the pond.
Why? To achieve economies of scale (lower costs in the long run) and to gain monopoly power so they can raise prices later. Think of tech startups that try to get everyone using their app first, even if they lose money at the start!
C. Profit Satisficing
This is a "good enough" approach. Instead of pushing for the absolute maximum profit, managers aim for a target level of profit that keeps the shareholders (owners) happy.
Why? This often happens in large companies where the owners (shareholders) are different from the managers. Managers might prefer a quiet life or focusing on their own interests once the shareholders are satisfied with a "decent" dividend.
Memory Aid - The "Three S's" of Alternative Goals:
- Sales (Revenue) Maximisation
- Share of the Market (Dominance)
- Satisficing (Good enough)
Common Mistakes to Avoid
1. Confusing Revenue and Profit: Revenue is the total money coming in; profit is what's left after costs. A firm can have huge revenue but still be losing money!
2. Forgetting the MC condition: On an exam, don't just say \( MR = MC \). Remember to add that MC must be rising.
3. Thinking firms are "stupid" for not maximising profit: Alternative objectives are often strategic. Losing money today to gain market share might lead to much higher profits in ten years.
Final Summary Table
Objective: Profit Maximisation
Condition: \( MR = MC \)
Logic: Maximise the gap between TR and TC.
Objective: Revenue Maximisation
Condition: \( MR = 0 \)
Logic: Sell as much as possible until adding more sales brings in zero extra money.
Objective: Profit Satisficing
Condition: Profit \( \ge \) Target Level
Logic: Keep the boss/shareholders happy while avoiding too much stress or risk.
Don't worry if the graphs for these look intimidating at first. Just remember the logic: Firms are like people—sometimes they want the most money, sometimes they want to be the most famous, and sometimes they just want to get through the day!