Differing Objectives And Policies Of The Firm

Question 1

Traditional profit maximising

Answer 1

1. The standard assumption about a firm’s obhective is to maximise profits.
   > A firm which is making a minimum level of normal profits is said to be producing at the break even output.
   > Most firms are preferred to make abnormal profits, TR > TC compared to normal profits, TR = TC, as a reward of risk taking.
2. Graph of profit maximisation rule
   X-axis: Output
   Y-axis: Cost and revenue

MC: upward sloping curve
D: downward sloping curve

Left: MR > MC - Profit margin
Point of intersection: MR = MC - Proft max output
Right: MC > MR - Loss on subsequent unit

A) MR > MC
> The firm is producing too little
> Firm earns more revenue than the cost incurred
> Firm can raise profit by increasing output
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B) MR = MC
> Total profit earned is the greatest
> Firm has no incentive to move away from this. point
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C) MC > MR
> The firm is producing too much and making a loss
> Firm can increase profit by decreasing output

3. Reasons why firms do not produce at MR = MC
   > In practice, it is difficult to identify this output level.
   » Usually firms will calculate the ATC and add on a standard profit margin to set the selling price.
   » This cost-plus pricing technique may not result in maximum output.
   > Large abnormal profit may attract new entrants into the industry, especially in the short run. In the long run, the firms usually earn normal profit.
   > May not be in the long term interest of the company.
   » Avoid the attention of government watchdog bodies.
   > High profits may damage the relationship between the firms and its stakeholders (consumers and consumer workforces).

Question 2

Other objectives of a firm

Answer 2

1. Sales revenue maximisation
   > Firm’s objective to maximise turnover.
   > A firm may prepare to accept lower prices in order to increase its market share. This is a penetration pricing policy.
   > Elasticity and total revenue graph.
   > Higher prices earn normal profit as consumers are more responsive to the price. Hence, firms try to go more inelastic.
   > Firms may choose to produce beyond MR = MC until MR = 0.
   > There may still be abnormal profit to earn if TR > TC.
   » Firms choosing this objective could see that their salary is linked wth sales revenue.
   > As TR increases, firms have better incentive hence workers’ salary increases.
   > The concept of PED from the firm’s point of view is that it determines what happens to TR when the firm changes price.
   » If the firm is having elastic demand, they could reduce price and boost total revenue.
   » For inelastic demand, firms should raise prices if they want to seek higher revenue.
2. Sales maximisation
   > Firm’s objective is to maximise volume.
   » Firm focuses on volume rather than sales revenue.
   » Sell as many products as possible without making a loss.
   > Firm increases output up to break even output where TR just covered TC.
   » Beyond this output implies loss-making.
   » Private sector would not go beyond the break-even output to expand sales, unless cross-subsidisation is practised.
   > There could be social objectives behind such price and output decisions.
   » Example, state-owned local bus services where the firm uses the profit from city services to retain lower density routes that are loss-making.
3. Satisfying
   > Occurs when a firm seeks to make a reasonable level of profits, sufficient to satisfy the shareholders but also keep other stakeholders happy.
   > Can also be referred to as ‘profit satisfying’ where the managers create a minimum level of profit to keep shareholders happy, but also maximise other profits.
   > Firms take into account of different competing objectives:
   » Shareholders expect good profits.
   » Workers expect a pay rise and good working conditions.
   » Consumers expect price stability and good service.
   > Firms will try to ensure all these objectives are met without attempting to maximise a single one.
4. Loss minimisation
   > Firm’s short term objective when a firm faces intense price competition or economic downturn to stay in business.
   > Survival becomes the priority.
   > There is a limit of time and scale of losses that can be incurred.
5. Ethical objective
   > Growing popular objectives among firms, as sometimes profit maximisation may not be in the best interest of the society.
   > Examples, damages to the natural environment caused pollution, and loss of scarce resources
   > Ethical objectives eat into a firm’s profits as they need to go extra lengths to ensure the supply chain is as fair as they claimed.
   > Therefore, the price changed may sometimes be higher than conventional trade manufacturers.
   > But the danger of not doing so is that consumers react unfavourably.

Question 3

Price discrimination

Answer 3

1. Occurs when a business changes different groups of consumers for the same good or service with different prices.
2. Aimed to increase profits by reducing consumer surplus.
   > Except for perfect competition, firms have a certain degree of price control (price maker) to price discriminate.
   > Examples, students or senior citizens concessions, and hard or soft cover of books.
3. 3 types of price discrimination
   A. First degree price discrimination
   > Also called perfect price discrimination.
   > Firm sells each unit of product to different consumers, charging each the price that they are willing to pay.
   > Charging each consumer a different price, based on ability to pay or income.
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   B. Second degree price discrimination
   > Consumers are willing to purchase more of a product if price falls when more units are brought.
   > Charging different prices depending on quality purchased.
   > Higher price is charged for the first unit followed by lower price as successive units are purchased.
   > Firms selling outputs that are deemed to be surplus at lower prices.
   > Consumers benefit from paying cheaper prices, firms benefit from increase in total revenue, total profits or clearing of extra inventory.
   > Examples, selling blocks of products in larger quantities, and price of fries or sodas in fast food restaurants.
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   C. Third degree price discrimination
   > Most common form of price discrimination.
   > Charging different prices to different groups of people.
   > Firms actively discriminate between consumers and based on different price elasticity of demand for the product.
   » Where consumers have low PED value, firms tend to charge higher prices for the product.
   > Common practice of third degree is students and senior citizens concessions.
4. Price discriminating monopolist
   > Graph
   » X-axis: Output
   » Y-axis: Cost and revenue
   AR above MR, starting from 60
   MC upward sloping curve
   ATC curve
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   > For a single price firm, profit maximisation output is where MR = MC.
   > If the firm practises third degree price discrimination, output is sold separately for what consumers would pay for each unit.
5. The overall outcome is not entirely predictable, though the firm’s revenue and profits should increase.
6. Necessary conditions for price discrimination:
   > Firms must have a certain degree of power in price setting (price maker).
   > Firms must be able to identify different market segments and charge different prices.
   > Different segments must have different PED:
   » Will only work with consumers who have a different willingness to purchase the product.
   » Consumers cannot resell to other consumers at higher prices based on their PED.
7. Advantages of price discrimination:
   > Higher total revenue
   > Benefits the counsumers with elastic demand
   > For first degree price discrimination, more equal distribution of the goods despite different ability to pay
   > For second degree price discrimination, it will encourage the consumers to purchase more quantities
   > Improves consumers’ satisfaction
8. Disadvantages of price discrimination
   > Unfair pricing as consumers pay different prices for the same goods and services
   > Consumers probably cheat to get the benefit of paying lower prices for the good

Question 4

Other pricing policy

Answer 4

1. Limit pricing
   > Involved firms set lower short run prices to discourage new entrants into the market so that they could continue to earn abnormal profit.
   > Pricing strategy used by monopolies or oligopolies to set price below profit maximising level, MR = MC in the short run, but still able to enjoy higher profits than in a perfect competition.
2. Predatory pricing
   > Seeks to remove existing firms from the market.
   > Occurs when a firm feels threatened when a new firm enters a market.
   > The established firm responds by setting a price that is so low that the new firm has no alternative but to match it.
   » The new firm cannot make a profit. In time, the new firm will be forced out of the market.
   » When this happens, the established firm will put its prices back to their former level.
   > Can be applied by two established firms in a market.
   » If one firm believes its rival is gaining market share, it can cut prices to protect its own market share.
   » If these cuts are deep enough and sustained over time, the rival firm may be forced to leave the market.
3. Price leadership
   > A common feature of oligopolistic markets.
   > It is seen as a way of avoiding price competition yet maximising total profits for all firms.
   > All firms in the market accept the price set by the leading firm, usually one with the largest market share.
   » When the leading firm announces a price increase, all others quickly follow, sometimes in just a matter of hours.
   » When a price fall is announced, smaller rivals are forced to follow the fall in price to retain market share.
   > However, the downside is that since their costs are higher, matching a price decrease could result in sustained losses and the eventual exit of smaller rivals from the market.
   > Graph
   » X-axis: Quantity
   » Y-axis: Price/Cost
   » D above MR. MCa and MCb

Question 5

Relationship between PED and firm’s revenue

Answer 5

1. Graph of Price/Output and Graph of Total revenue/Output
2. The firm would be facing a straight-line demand curve.
   > The consumers’ reaction to a price change varies at different rpices since the PED varies along the demand curve.
3. A relationship between price elasticity and marginal revenue can be seen.
   > When PED > 1, MR is positive and total revenue will be increasing as output increases.
   > When PED = 1, MR = 0 and total revenue will be maximised.
   > When PED < 1, MR is negative, reducing the total revenue.
4. The most important thing about the concept of price elasticity from the firm’s point of view is that it determines what happens to total revenue when the price is altered.
   > It would make sense for any firm operating in the elastic part of the demand curve to reduce price and boost total revenue.
   > In the elastic part, the firm should raise its price if it wants to see higher revenue.
   > This in itself is a reasonable objective for a firm to have, however, not the same as profit maximisation.
5. Penetration pricing policy
   > A firm may be prepared to accept a lower price and produce above the profit-maximising output in order to increase its market share in a growing market.
   > A firm choosing to maximise its revenue would raise output beyond MR = MC until MR had fallen to zero.
   > Extra sales after this would contribute nothing to total revenue.
   > There may still be supernormal profit if total revenue is higher than total cost, TR > TC but this depends on the elastciity of the goods.
6. Kinked demand curve
   > A means of analysing the behaviour of the firms in oligopoly where there is no collusion.
   > This model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions (how one firm reacts depends how it expects its competitors to react).
   > It also form expectations about how consumers will react to price change.
   > Graph of kinked demand curve
   » X-axis: Quantity
   » Y-axis: Price/Cost
   > Kinked demand curve is a demand curve with two distinct segments which have different elasticities that join together.
   » One segment is relatively more elastic for price increase.
   » Second segment is relatively inelastic for price decrease.
   > Vertical MR shows the range of profit maximisation at the same price and same quantity.
   » If firms lower prices below P, it will have strong reactions from competitors, causing MR to drop dramatically.
   > Kinked demand curve - increase in MC
   » If MC increases from MC to MC1, profit amximisation remains at the vertical part of MR.
   » Produce at P and Q as well.
   » Firm A is able to absorb the cost increase without changing the price and quantity combination from initial P and Q.
   » Otherwise, a decrease in MC remains at the vertical part of MR allows Firm A to enjoy the cost decrease without changing the price and quantity combination from initial P and Q.
   > Kinked demand curve provides insight into why oligopoly markets tend to keep prices relatively constant.
   » Explains why firms in oligopoly produce the same quantity at the same price although there is an increase or decrease in marginal costs.
   » If one reduces price, price war will start and firms earn less profits.
   » Hence, firms prefer non-price competition.
   > Limitations of kinked demand curve:
   » Do not explain why price in some oligopolistic markets is more rigid than others.
   » The price rigidity could be due to commercial practice rather than the firm’s awareness of the kinked demand curve.
   » Over time, game theory has increasingly been applied to understand the behaviour of oligopolists.