7.8 Differing objectives and policies of firms

Question 1

What is the traditional theory of firms?

Answer 1

Profit is an important objective of most firms. Models that consider the traditional theory of the firm are based upon the assumption that firms aim to maximise profits.

Question 2

What is the profit formula?

Answer 2

It is total revenue - total costs.

Question 3

When do firms break even?

Answer 3

Firms break even when TR = TC.

Question 4

When is a firm profit maximising?

Answer 4

A firm profit maximises when they are operating at the price and output which derives the greatest profit.
Profit maximisation occurs where marginal cost (MC) = marginal revenue (MR). In other words, each extra unit produced gives no extra profit or no extra revenue.
MC = MR

Question 5

Why do firms decide to profit maximise? and why do firms not decide to profit maximise?

Answer 5

Some firms choose to profit maximise because:

It provides greater wages and dividends for entrepreneurs
Retained profits are a cheap source of finance, which saves paying high interest rates on loans
Lower costs and lower prices for consumers. Businesses keep costs low in order to kee profits very high and this lower cost is passed onto consumers
To reward entrepreneurship
In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company.
Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run, so this will provide a stable price and output

Some firms choose to not profit maximise because:
Knowledge of MC and MR is insufficient
To avoid scrutiny. Regulators may see loads of profit and think they are being dodgy. Usually the outcomes of investigation are anti the interest of businesses. Forces to lower price or be more environmentally friendly etc. They usually increase costs and reduce revs for businesses
Key stakeholders could be harmed if a business goes too hard with profit maximising
Other objectives may be more important

Question 6

Why are PLCs particularly keen on profit maximising?

Answer 6

PLCs are particularly keen to profit maximise, because they could lose their shareholders if they do not receive a high dividend. They are more likely to have short-run profit maximisation as an objective, because they need to keep their shareholders happy.

Question 7

What is normal profit?

Answer 7

Normal profit is the minimum reward required to keep entrepreneurs supplying their enterprise. It covers the opportunity cost of investing funds into the firm and not elsewhere. This is when total revenue = total costs (TR = TC).
Normal profit is considered to be a cost, so it is included in the costs of production

Question 8

What is supernormal profit?

Answer 8

Supernormal profit (also called abnormal or economic profit) is the profit above normal profit. This exceeds the value of the opportunity cost of investing funds into the firm.
This is when TR > TC.

Question 9

Correlation between PED and total revenue

Answer 9

Total revenue is equal to average price times quantity sold. TR= P x Q
If a good has an inelastic demand, the firm can raise its price, and quantity sold will not fall significantly. This will increase total revenue.
If a good has an elastic demand and the firm raises its price, quantity sold will fall. This will reduce total revenue.

Question 10

What are the other objectives of firms?

Answer 10

Survival: Some firms, particularly new firms entering competitive markets, might aim to simply survive in the market. This is a short term view. During periods of economic decline such as the 2008 financial crisis, when consumer spending plummets, firms might have survival as their objective, until there is economic growth again. Firms might aim to sell as much as possible to keep their market position, even if it is at a loss in the short run. It is a short term objective

Public sector organisations (P=MC)
Max society interest and welfare. They aim to price and produce where demand = supply. So P = MC

CSR’s:
Following ethics and social responsibility becoming more important. Giving to charity, sustainability, paying workers n suppliers well

Quality: Firms might aim to increase their competitiveness by improving their quality. Firms might consider improving their customer service or the quality of the good they produce. This could be achieved through innovation. If firms can gain a reputation for high quality goods, they could potentially charge higher prices, since consumers might be willing to pay more for them.

Question 11

What is profit satisficing?

Answer 11

A firm is profit satisficing when it is earning just enough profits to satisfy as many key stakeholders as possible.
Shareholders want profits since they earn dividends from them. Managers might not aim for high profits, because their personal reward from them is small compared to shareholders. Therefore, managers might choose to earn enough profits to keep shareholders happy, whist still meeting their other objectives.
This occurs where there is a divorce of ownership and control.

Effect of prof max on key stakeholders
Shareholders happy with profit max
Managers higher bonuses and incomes
Consumers might not be happy if prices are way too high
Workers and trade unions might not like it as they might have to suffer lower wages to cut costs
Gov may not like it if excess prices are charged for consumers n wages low for workers
Environmental groups might not like it if they cut costs by sacrificing environment

If you harm consumers you suffer from bad reputation.
Workers could strike.
Gov can investigate if they’re not happy with how business is doing.
Environmental groups can protest which can ruin reputation which is very important.

Question 12

What is price discrimination?

Answer 12

Price discrimination occurs in a monopoly, when the monopolist decides to charge consumers different prices, for the same good or service with no difference in costs of production. This is not for cost reasons.

A market with an elastic demand curve will have a lower price and opposite for inelastic demand curve

Question 13

What is 1st degree price discrimination?

Answer 13

First degree price discrimination is when each consumer is charged the exact price they are willing and able to pay. Erodes all consumer surplus and turns it into monopoly profit.

Question 14

What is 2nd degree price discrimination

Answer 14

Second degree price discrimination is when there are excess capacity. Last minute deals

Last min lowering of prices in order to get rid of spare capacity and turn it into profits. Airline companies / cinemas etc
They lover price to p2 which is where all spare capacity will be filled (the vertical part of the MC curve)

Question 15

What is 3rd degree price discrimination?

Answer 15

Third degree price discrimination is when a firm is able to segment a market into different PED’s

Rail company identifies inelastic demand , commuters who need to get to work and PED leisure travellers

Question 16

Conditions necessary for price discrimination?

Answer 16

Price making ability —-> monopoly power
Information to separate the markets —-> identify the ones with price inelastic demand so they can charge more
Prevent resell of the good (market seepage)

Question 17

What are the pros and cons of price discrimination?

Answer 17

Pros
Dynamic efficiency which means more reinvestment through greater profits
Greater Economies of scale benefits with higher quantities being sold - lower prices to consumers over time
SOME consumers benefit 2nd and 3rd degree. Through things like deals or elastic consumers
Cross subsidisation - higher profits may be used to subsidise other loss making goods in a business

Cons
Allocative inefficiency - exploiting consumers drastically with such high prices
Inequalities - if those consumers being discriminated against are on lower incomes, it can widen income inequality in society
Anti-competitive pricing - lower pricing can drive out other firms and we don’t want that as monopoly power would be created

Question 18

What is predatory pricing?

Answer 18

Predatory pricing involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses. As firms leave, the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs. This reduces contestability.

Question 19

What is limit pricing?

Answer 19

Limit pricing discourages the entry of other firms. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms

Question 20

What is price leadership?

Answer 20

Price leadership refers to a situation where prices and price changes are established by a dominant firm which other firms in the industry adopt and follow.

Question 21

What is revenue maximisation and why do firms aim for that?

Answer 21

This is when MR=0

For economies of scale benefits, rev max quantity is greater than prof max quantity and with that comes greater growth greater eos lower cost so lower prices for consumers.
Predatory pricing - rev max price lower than prof max price which means a dirty tactic like this takes place. This is when a firm will undercut its rival in order to drive out competitors of the market
Principle agent problem - divorce between ownership and control. Managers control, shareholders own. Managers run the day in and day out and they might decode to rev max in order to use as leverage and ask for perks in their job.

Question 22

What is sales maximisation and why do firms aim for that?

Answer 22

This is when AC = AR
Business wants to be as large as they can possibly be without making a loss. (break even)

Economies of scale
Limit pricing - break even price at normal profit takes away the incentive for new firms to enter the market. Still dodgy
Principle agent problem which means their is a divorce of ownership of control. Managers may use growth or sales as their leverage to get these perks in their jobs.
Another benefit is to flood the market. Lots of consumers become more aware of your product which builds loyalty towards it. Then later down the line u can change ur objectives to profit max.