A2 Micro: Moving Away from Profit Max

The standard theory of the firm assumes that businesses have enough information, market power and motivation to set prices that maximise profits. But this assumption is now criticised by economists who have studied the organisation and objectives of modern-day corporations. Not only do most businesses frequently move away from pure profit seeking behaviour, many are nor organised and set up in a way where profit is not the only objective.

There will always be a range of business objectives: 1. Profit maximisation 2. Revenue maximisation 3. Increasing and protecting market share 4. Surviving an economic downturn 5. Pursuing ethical business objectives 6. Providing a public service

There are numerous possible explanations. Some relate to the lack of accurate information required to set profit maximising prices. Others concentrate on the alternative objectives of businesses.

We start first with the effects of imperfect information. It might be hard for a business to pinpoint precisely their profit maximising output, as they cannot accurately calculate marginal revenue and cost. Often the day-to-day pricing decisions of businesses are taken on the basis of “estimated demand conditions” or “rules of thumb”. Or a business might simply look to add a profit margin on top of their average cost – this is known as “cost-plus pricing”.

Secondly, most businesses are multi-product firms operating in a range of markets across countries and continents – as a result the volume of information that they have to handle can be vast. And they must keep track of the ever-changing preferences of consumers. The idea that there is a neat, single profit maximising price is redundant.

Behavioural Theories of the Firm

Behavioural economists believe that modern large-scale businesses are complex organizations made up various stakeholders. Stakeholders are defined as any groups who have a vested interest in the activity of a business. Examples might include:
o Managers employed by the firm
o Shareholders – people who have an equity stake in a business
o Customers
o The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at points in time. The dominant group at any moment can give greater emphasis to their own objectives – for example price and output decisions may be taken at local level by managers – with shareholders taking only a distant and imperfectly informed view of the company’s performance and strategy.

If firms are likely to move away from pure profit maximising behaviour, what are the alternatives?

1. Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit.

2. Sales Revenue Maximisation
The objective of maximising sales revenue rather than profits was initially developed by the work of William Baumol whose work focused on the behaviour of manager-controlled businesses. Baumol argued that annual salaries and other perks might be closely correlated with total sales revenue rather than profits. Companies geared towards maximising revenue are likely to make frequent and extensive use of price discrimination as a means of extracting extra revenue and profit from consumers.

3. Managerial Satisfaction model
An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue.

Price and output differs if the firm changes its objective from profit to revenue maximisation. Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective.

A change in the objectives of the business has an effect on welfare. Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised