Firms’ Objectives________________________________________________________Profit Maximisation

If revenue is greater than costs then there are supernormal/abnormal profits Occurs at the output level where supernormal profits are at their greatest Profit Max: MC = MR In addition to this, at this point MC must be rising:

In the graph:- At an output of 1, marginal profit is 0, i.e. there is no profit from the last unit sold- The next time that marginal profit is 0 (output of 5) the firm is maximising its profits

– each unit sold between one and five is adding to total profit.- See table below.

Output Marginal Revenue Marginal Cost Marginal Profit Total Profit 1 £10 £10 £0 £02 £10 £6 £4 £43 £10 £3 £7 £114 £10 £6 £4 £155 £10 £10 £0 £156 £10 £13 -£3 £12

However:- Do firms (e.g. local pubs and coffee shops) know the marginal cost of a pint of beer

or a cup of coffee?- If they knew the level of output would they stop selling because the next item would

result in a fall in total profit? - Long run – if consumers dislike price changes (as market conditions change) long

run profit levels will be enhanced by the maintenance of a stable price – possible that price will only be changed when it becomes clear that a change in market conditions will persist into the long run – particularly true when firms pursue price mark-ups (price = cost of production plus a percentage known as cost-plus pricing) – only thing that will change the price then is a long run shift in cost conditions or a change in market conditions.

- Long term profit maximising might entail forward looking policies that would be rejected by a company more interested in short term profit levels.

Sales Revenue Maximisation

Where firms are willing to sell units until the next unit sold will reduce revenue. Revenue Max: MR = 0

In the graph:- As the firm expands output, marginal revenue declines

1

- However, while marginal revenue is still positive it is still adding gradually smaller amounts to total revenue

- When MR passes 0 and becomes negative, however, total revenue starts to decline

If a firm pursues sales revenue maximisation it is likely to have a bigger share of the market than if it is profit maximising.

Sales Volume Maximisation

When a firm wants to maximise the number of units sold This means that they maximise their share in the market Volume Max: AC = AR=D

In the graph:- Price is set at Ps- This is because at any price below Ps AC>AR meaning that losses are made- PsQs is therefore the level at which the quantity is maximised whilst normal profits

are still being made.

Other Theories

These arise due to the debate over who really controls the firm:

2

Ps

Qs

Shareholders own the firm and want to maximise profits for dividends BUT they have little direct input into the day-to-day running of the firm.

Board of directors may have other objectives than making profits. This illustrates the principal-agent problem – the manager (agent) does not always

act in the best interest of their shareholders (the principal). Decision makers on key strategic objectives by the board of directors of a PLC is likely

to be subject to more constraints than in a private limited company:- PLCs can trade shares openly on the Stock Exchange – anyone can buy the shares

and attend the Annual General Meeting, questioning board members.- Pressure groups such as Greenpeace have bought shares in PLCs who may not have

been taking enough care (in their opinion) of the environment – they may not be able to exert real power but they can articulate their viewpoints effectively.

Behavioural theories:

Managerial:- Managers control the company- They may have their own agenda – maximise their personal welfare or ego- Perks and status aren’t always tied to profit maximisation – managers make

enough profit to prevent a shareholder revolt, while still enjoying the perks afforded by not striving to maximise profits

- They may aim to grow the business/take over rival firms - May try to maximise their own short-term bonus while taking significant risks

with the future viability of the business Satisficing:

- US economist Herbert Simon argued that decision making within a company results from the interaction between many competing groups within the firm

- A solution is satisficing – compromises between different groups in the firm which may be seen as satisfactory – minimum targets may be set for objectives, and this may carry on until more difficult trading conditions occur, then managers will remove organisational inefficiency (X-inefficiency) in the firm by e.g. reforming work practices and announcing redundancies.

Other goals:

Satisfying stakeholders (customers, employees, shareholders, lenders etc.) – i.e. those who have an interest in the activities of the firm

Airline sector – ‘load factor’ – airlines may be aiming for an 85% load factor (number of seats filled) – important where costs are fixed

Network Rail – more emphasis on safety and maintenance than its more profit-motivated predecessor, Railtrack

Ethical and environmental objectives – more important to firms operating in sensitive areas of production such as oil and chemicals

Common for large firms to produce annual social audits of their activities – examine the positive and negative effects of the firm’s operations on the wider society

Pricing strategies:

Designed to gain market share.- Predatory pricing: pricing at a level low enough to drive out firms currently in

the industry by reducing profitability.

3

- Limit pricing: pricing at a level low enough to limit profits, which has the effect of discouraging new entrants from joining the industry.

Short run – limit and predatory pricing will benefit the consumer by providing them with low prices.

However – long run when the firm has managed to drive rival firms out of the industry and gained monopoly power, it will be able to raise prices, reducing consumer surplus and exploiting the consumer.

Non-pricing strategies:

Particularly relevant when firms sell goods which cannot be discounted heavily or where some form of collusion takes place.

Includes:- Advertising- Branding- Packaging- After care/customer service/warranties- Product development and innovation- Product placement – the type of retail outlet in which the good is sold

4