7.8 Differing Objectives and Policies of Firms

Chapter 7.8: Differing Objectives and Policies of Firms

7.8.1 Traditional Profit-Maximising Objective of Firms

Definition:
Profit maximization is the classical objective of firms in economics. It means producing at the level of output where marginal cost (MC) equals marginal revenue (MR). This ensures the firm earns the highest possible profit.

Formula:
Profit = Total Revenue (TR) – Total Cost (TC)
Maximization occurs where: MC = MR

Assumptions:

• Firms are rational and aim to maximize profits.

• They have full knowledge of their costs and revenues.

• Markets are competitive or imperfect, but prices respond to marginal analysis.

Evaluation:

• While this is the assumed goal in theory, real-world firms may not always operate under perfect conditions or prioritize profit maximization alone.

7.8.2 Other Objectives of Firms

In practice, firms may pursue multiple or changing objectives depending on their size, stage, market structure, ownership, or macroeconomic conditions.

a) Survival:

• Especially relevant for new firms, startups, or during economic downturns.

• Firms may cut prices, accept losses, or reduce output to stay in business.

• More crucial than profit in short-run crises.

b) Profit Satisficing:

• Originates from Herbert Simon’s theory of bounded rationality.

• Instead of maximizing profit, firms aim to earn “satisfactory” levels to keep stakeholders happy.

• Common in companies with Principal-Agent Problem, where managers (agents) don’t own the firm and settle for acceptable profit while pursuing other goals.

c) Sales Maximisation:

• Focus on selling the maximum volume of goods/services, even if it means lower profit margins.

• Encouraged by:

• Economies of scale.

• Pressure to increase market share.

• Incentive structures based on turnover.

• Maximum sales occur when Average Revenue (AR) = Average Cost (AC).

d) Revenue Maximisation:

• Seeks to maximize total revenue (TR = Price × Quantity).

• Happens when MR = 0.

• Useful in building brand recognition or discouraging new market entrants.

• May lead to lower prices and high output, benefiting consumers in the short run.

7.8.3 Price Discrimination – First, Second and Third Degree

Definition:
Price discrimination occurs when a firm charges different prices to different consumers for the same product, without any cost justification.

Conditions Required for Effective Price Discrimination:

1. Market Power – the firm must be able to influence price (not in perfect competition).

2. Market Separation – consumers must be segmented by elasticity, age, income, etc.

3. Prevention of Resale – consumers shouldn’t be able to resell at lower prices.

Types of Price Discrimination

1. First-Degree Price Discrimination (Perfect):

• Firm charges each consumer the maximum they are willing to pay.

• All consumer surplus is extracted.

• Rare in practice, but examples include auctions or personalized pricing online.

2. Second-Degree Price Discrimination:

• Price varies according to quantity purchased or product version.

• Examples:

• Bulk discounts

• Electricity pricing (per unit)

• Airline seat classes (economy vs business)

3. Third-Degree Price Discrimination:

• Different prices for different consumer groups.

• Based on identifiable traits like age, geography, or time of purchase.

• Examples:

• Student and senior citizen discounts

• Off-peak pricing for transport

• Regional pricing (cheaper books in South Asia)

Consequences of Price Discrimination:

Positive:

• Increases firm revenue and profit.

• May lead to greater output and efficiency.

• Allows cross-subsidization (e.g., discounts to low-income groups).

Negative:

• Seen as unfair or exploitative.

• May reduce consumer surplus.

• Can lead to regulatory issues or loss of trust.

7.8.4 Other Pricing Policies

Firms often adopt strategic pricing to deter entry or dominate markets.

1. Limit Pricing:

• Firm sets price just low enough to discourage new entrants.

• Not necessarily profit-maximizing in the short run but maintains market dominance.

• Prevents potential competitors from entering due to low expected returns.

2. Predatory Pricing:

• Price set below average cost to drive rivals out of the market.

• Once competitors exit, firm raises price again.

• Illegal in many countries (anti-competitive practice).

• Short-term loss for long-term gain.

3. Price Leadership:

• In an oligopoly, the dominant firm sets the price.

• Other firms follow the leader to avoid price wars.

• Maintains price stability in markets with few players.

• Can be tacit collusion (not formal but coordinated behavior).

7.8.5 Price Elasticity of Demand and a Firm’s Revenue

A. In a Normal Downward Sloping Demand Curve:

• Elastic Demand (PED > 1):

• Price ↓ → TR ↑

• Price ↑ → TR ↓

• Revenue moves in opposite direction of price.

• Inelastic Demand (PED < 1):

• Price ↓ → TR ↓

• Price ↑ → TR ↑

• Revenue moves in same direction of price.

• Unitary Elasticity (PED = 1):

• Change in price does not affect total revenue.

• This is the revenue-maximizing point.

Diagram suggestion: TR curve peaks when PED = 1.

B. In a Kinked Demand Curve (Oligopoly):

• Price increases: demand is elastic, rivals don’t follow → customers switch.

• Price decreases: demand is inelastic, rivals follow → minimal gain in quantity sold.

• Result: Firms avoid price changes → price rigidity in oligopoly.

• Explains why prices often remain stable even when costs change.

Diagram features:

• Kink at current price.

• MR curve has a discontinuous vertical gap.

Conclusion:

The objectives and policies of firms go beyond textbook profit maximization. Depending on the industry and market structure, firms can pursue goals like survival, revenue growth, or even ethical aims. Their pricing behavior reflects this complexity, from discriminatory pricing to strategic deterrence and elasticity-based decisions. Understanding these concepts equips students to analyze real-world business strategies critically.