Differing Objectives and Policies of Firms

Contents: 10 sections

1. Why this topic matters

Everything in 7.6 assumed firms maximise profit. This topic examines the cases where they do not, and the pricing policies firms actually use, neither of which follows from MC = MR.

Candidates who can only run the profit-maximising rule lose marks across a whole family of questions: a firm told to maximise revenue produces where MR = 0, and a question about a firm charging two prices for the same good is not about market structure at all.

2. The traditional profit-maximising objective

Diagram walkthrough · 2 minWhy MC equals MR is the profit-maximising pointEconplusDalWhy firms profit maximise before where they do it: reinvestment in capital, technology and research, dividends for the shareholders whose finance made the firm possible, lower costs that can be passed on as lower prices, and a reward for the risk taken in starting up. Then the rule itself, marginal cost equals marginal revenue, argued rather than asserted. Past that point every extra unit costs more than it earns and eats into profit; before it every extra unit earns more than it costs, so stopping early leaves profit on the table.

The standard assumption is that a firm chooses the output where MC = MR, provided MC is rising through MR, then reads the price from the AR curve at that output.

The justification is that owners want the largest return on their capital, and in a competitive market a firm that does not maximise profit will be driven out or bought by someone who will.

3. Why the assumption can fail

Real-world case · 2 minWhy Boeing kept rebuilding a 50-year-old planeWendover ProductionsA firm choosing NOT to do the obviously better thing, which is where objectives stop being a list and start being a decision. The 737 MAX is a fifty-year-old design re-engined and reworked three times, much of it drawn by people no longer alive. In 2011 an all-new single-aisle plane looked like the logical move. What overruled it was the economics of the industry and the Boeing and Airbus rivalry, which is a concrete answer to why real firms depart from the textbook choice.

In a small owner-managed firm the person taking decisions is the person receiving the profit, so profit maximisation describes behaviour reasonably well. In a large company ownership is spread across shareholders while decisions are taken by salaried managers. This is the divorce of ownership from control.

3.1 The principal-agent problem

The principal-agent problem follows from that divorce. Shareholders are the principals, managers are their agents, and the two want different things. Managers may prefer growth, prestige, a quieter life or a larger department, because salary, status and job security track the size of the firm more closely than they track its profit.

Shareholders cannot observe managerial effort directly, so this is a case of asymmetric information, the same structure as the insurance and second-hand car examples in 7.4.

Firms respond with share options, performance-related pay and reporting requirements, which align the agent's interest with the principal's without ever removing the problem entirely.

Note that the problem does not require anyone to behave dishonestly. It arises from divergent objectives under imperfect information, and it exists even when everyone is acting in good faith.

4. Other objectives of firms

Each objective has a condition, and the condition is what earns the mark.

Objective	Condition	Output compared with profit maximisation
Profit maximisation	MC = MR	benchmark
Revenue maximisation	MR = 0	higher output, lower price
Sales maximisation	AR = AC	highest output, lowest price
Profit satisficing	no single rule	indeterminate
Survival	cover costs, hold cash	usually lower

4.1 Revenue maximisation

The firm produces where marginal revenue is zero, because beyond that point selling another unit reduces total revenue. Managerial pay linked to turnover, or a desire for market share, can motivate it.

4.2 Sales maximisation

The firm pushes output as far as it can while still covering average cost, so AR = AC and it earns normal profit and no more. Beyond that point it would make a loss. This gives the largest output and the lowest price of any of the objectives.

Note the distinction Cambridge draws: revenue maximisation is about the value of sales, sales maximisation is about the volume.

4.3 Profit satisficing

Satisficing means achieving an outcome good enough to keep shareholders, employees, lenders and regulators sufficiently content, rather than the best possible on any one measure. It is the realistic description of a firm answering to several stakeholders with conflicting demands, and it follows naturally from the principal-agent problem: managers need only deliver profit sufficient to avoid being replaced.

4.4 Survival

Survival dominates in a recession, for a new entrant, or for a firm in a price war. It can justify pricing below average total cost in the short run, which connects directly to the shutdown rule in 7.6: a firm continues while price covers average variable cost.

4.5 What follows for price and output

Every alternative to profit maximisation produces more output at a lower price, because each continues past the profit-maximising output. Two consequences worth stating in an essay:

consumers gain in the short run from the lower price and larger quantity; but
the firm forgoes profit that could have funded investment and innovation, which is the dynamic efficiency argument from 7.6.

4.6 Evaluation

Do not present the alternatives as a refutation of profit maximisation. Competition disciplines objectives. A firm in a contestable market that sacrifices profit for a quiet life invites entry, and a company whose share price falls far enough invites a takeover that replaces its managers. The alternatives are most durable where market power is greatest, which is exactly where the profit-maximising model was already least descriptive.

5. Price discrimination

Price discrimination is charging different prices to different consumers for the same good, where the difference is not justified by a difference in cost.

The qualification matters. A train ticket that costs more at peak time may simply cost more to supply, and that is not price discrimination. Charging a student less for an identical seat is.

5.1 Conditions for effective price discrimination

The firm must have price-making power, so it cannot be a perfect competitor.
The market must be separable into groups with different price elasticities of demand.
Resale must be prevented, or those charged the low price would buy and sell on to those charged the high price, destroying the scheme. This is why it is common in services, which cannot be resold, and rare in easily transported goods.
The cost of separating the markets must be less than the extra revenue it generates.

5.2 The three degrees

First degree, sometimes called perfect price discrimination: every consumer is charged the maximum they are willing to pay, so the whole of consumer surplus is converted into producer surplus. It requires knowing each buyer's willingness to pay, so it is rare, though data-rich online pricing moves towards it.
Second degree: price varies with the quantity or version purchased rather than with the identity of the buyer. Bulk discounts, block tariffs for electricity, and cheaper unit prices on larger packs are examples. Consumers sort themselves.
Third degree: different prices to identifiable groups with different elasticities, such as student, child and senior fares. This is the most common form and the one most often examined.

The pricing rule for third degree is that the firm charges the higher price in the market with the more inelastic demand.

5.3 Consequences

Against price discrimination:

consumers with inelastic demand pay more, and consumer surplus is transferred to the firm;
it is a use of market power, so it may signal weak competition; and
first degree discrimination removes consumer surplus entirely.

For price discrimination:

total output usually rises, because consumers in the elastic market are served at a price they would not have paid under a single price;
some consumers therefore pay less than they would under uniform pricing, and some services exist only because discrimination makes them viable;
the extra profit may fund investment, or cross-subsidise loss-making services; and
it can improve capacity utilisation, as with off-peak fares.

The balanced judgement is that price discrimination redistributes surplus from consumers to the firm while often increasing the quantity traded, so the welfare effect depends on which of those dominates and on who the low-price group turns out to be.

6. Other pricing policies

6.1 Limit pricing

Limit pricing sets price below the profit-maximising level but above average cost, deliberately low enough to make entry unattractive to a potential rival. The incumbent trades current profit for continued protection, so it is only rational where the threat of entry is real. It links directly to contestability in 7.6.

6.2 Predatory pricing

Predatory pricing sets price below cost with the aim of driving an existing rival out, after which price is raised. It differs from limit pricing in both the level, below cost rather than merely below the profit-maximising price, and the target, an existing rival rather than a potential entrant.

It is illegal in most jurisdictions, and it is hard to prove, because a low price is also what vigorous competition looks like. The evaluation is that predation only pays if the losses incurred can be recovered afterwards, which requires barriers to entry high enough to stop the victim, or someone else, returning once the price rises.

6.3 Price leadership

Under price leadership one firm, usually the largest or the lowest-cost, changes its price and the others follow. It produces a coordinated outcome without any agreement, so it is a form of tacit collusion and leaves competition authorities with nothing to point to. It is a natural response to the interdependence of oligopoly described in 7.6.

7. Price elasticity of demand and firm revenue

The link between elasticity and revenue governs whether any pricing policy raises or lowers turnover.

7.1 Along a normal downward-sloping demand curve

Where demand is price elastic, a price cut raises total revenue, because the proportionate rise in quantity exceeds the proportionate fall in price. Marginal revenue is positive.
Where demand is unit elastic, total revenue is at its maximum and marginal revenue is zero.
Where demand is price inelastic, a price cut lowers total revenue. Marginal revenue is negative.

A profit-maximising firm therefore never operates on the inelastic section of its demand curve, because it could raise price, sell less, earn more revenue and incur less cost at the same time.

7.2 The kinked demand curve

The kinked demand curve model explains price rigidity in oligopoly. It assumes that if one firm raises its price, rivals do not follow, so it loses many customers and demand is elastic above the current price. If it cuts its price, rivals match to protect share, so it gains few customers and demand is inelastic below it.

The two segments meet at a kink at the prevailing price, and the marginal revenue curve has a vertical discontinuity beneath the kink. Marginal cost can therefore shift within that gap without changing the profit-maximising output or price, which is the model's central prediction: prices in oligopoly are stable even when costs move.

Its acknowledged weakness is that it explains why the current price persists but not how that price was arrived at in the first place.

8. Integrated analysis and common traps

8.1 A complete chain

A rail operator with market power introduces off-peak fares 40 per cent below the peak fare for identical journeys.

Analysis: this is third degree price discrimination. Peak travellers are commuters with inelastic demand, off-peak travellers are leisure passengers with elastic demand, resale is impossible because tickets are time-stamped and often named, so all the conditions hold. The firm charges the higher price in the inelastic market.

Evaluation: consumer surplus is transferred from commuters to the operator, which is a distributional loss falling on people with the least choice. Against that, off-peak journeys are made that would not otherwise happen, capacity is used more evenly across the day, and the extra revenue may fund investment. Whether this improves welfare depends on the weight placed on the transfer against the extra output, and on whether the operator faces any competitive discipline at peak times.

8.2 Common examination errors

Applying MC = MR to a firm that is not maximising profit.
Confusing revenue maximisation (MR = 0) with sales maximisation (AR = AC).
Explaining the principal-agent problem as managerial dishonesty rather than divergent objectives under asymmetric information.
Calling any price difference price discrimination, when a cost difference makes it something else.
Forgetting that preventing resale is a necessary condition.
Stating that price discrimination always harms consumers, ignoring the output effect.
Confusing limit pricing with predatory pricing. Limit pricing is above cost and aimed at entrants; predatory pricing is below cost and aimed at existing rivals.
Drawing the kinked demand curve without the discontinuity in marginal revenue, which is the whole point of the model.

9. Paper 3 and Paper 4 mastery

Paper 3 tests: identifying the output condition for a stated objective, classifying a degree of price discrimination, distinguishing limit from predatory pricing, and reading the effect of a cost change on a kinked demand diagram.

Paper 4 asks whether firms do maximise profit, or whether price discrimination should be permitted. For the first, set the profit-maximising case against the principal-agent evidence and conclude on how far competition disciplines managers. For the second, separate the transfer of surplus from the change in output, and be explicit that the two point in different directions.

Check you have it

A firm abandons its policy of horizontal expansion and switches to a policy of backward vertical growth. What does this suggest is most likely about the firm’s objectives?

Answer: D. Backward vertical growth means acquiring the firms that SUPPLY the business, which secures its inputs and protects it against disruption or price rises by suppliers. Horizontal expansion, the policy being abandoned, means acquiring rivals at the same stage of production, which is a way of buying MARKET SHARE. The switch therefore signals a change of priority from market share towards security of supply, which is D. A contrasts revenue maximisation with cost minimisation, and neither type of merger is chosen on that basis. B contrasts sales maximisation with satisficing, and again neither growth strategy tells you which of those the firm now pursues. C names security of SALES, which would point towards buying distributors or retailers, and that is FORWARD vertical growth, the opposite direction of travel from the one the question describes.

More questions on differing objectives and policies of firms →

10. Final checklist

A fully prepared learner can:

state the profit-maximising condition and explain why it may not describe a large company;
explain the divorce of ownership from control and the principal-agent problem as asymmetric information;
state the condition for revenue maximisation, sales maximisation, satisficing and survival;
explain why every alternative objective gives more output at a lower price;
define price discrimination and state its four conditions, including the prevention of resale;
distinguish first, second and third degree price discrimination with an example of each;
evaluate price discrimination by separating the surplus transfer from the output effect;
distinguish limit pricing, predatory pricing and price leadership by level and by target; and
draw and explain the kinked demand curve, including the discontinuity in marginal revenue.