Revision: Moving Away from Profit Maximisation

The traditional theory of the firm which assumes that businesses possess sufficient information, market power and motivation to set prices or their products that maximise profits is outdated. A2 students need to understand the circumstances in which a firm / business will not seek to maximise profits (where MR=MC) - this revision note covers this issue:

1/ Lack of full information on revenue and costs - many businesses cannot accurately calculate marginal revenue and marginal costs. Often the day-to-day pricing decisions of businesses are taken on the basis of “estimated demand conditions” or rules of thumb. Instead of relying on information about marginal cost and revenues, many businesses operate with a simple mark up between price and average cost. The mark up may change as and when demand changes.

2/ Macroeconomic conditions: In a recession, pure profit maximisation may give way to pricing designed to maintain sales, clear unsold stocks and generate cash flow. Short term profits can be sacrificed in place of a strategy designed to increase cash reserves and keep a business afloat.

3/ Behavioural theories of the firm: Behavioural economists believe that modern corporations are complex organizations made up various stakeholders. Managers of businesses may have different objectives than their shareholders. For example, satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit. Managers might also decide to opt for a sales revenue maximising model (where MR=zero) perhaps as part of a bid to increase market share and improve their commission or sales based salaries.

4/ Not just for profit businesses: Underneath the surface of an economy dominated by corporate giants, a new breed of business is flourishing, where profit is not always the bottom line; these are entrepreneurs operating for a social purpose and not just for profit. A social enterprise is a business that has social objectives whose surpluses are reinvested for that purpose in the business or the community, rather than being driven by the need to seek profit to satisfy investors. Rather than maximise shareholder value and distribute dividends, a social enterprise is looking to achieve social and environmental aims over the long term. The Royal Mail is required to maintain a loss-making universal national postal delivery service throughout the UK for a uniform price.

Key revision points:

a) Be aware of different business / commercial / social objectives
b) Analyse how these might lead to changes in price, output and economic welfare using cost and revenue curves
c) Understand the ways in which objectives might change at different stages of the economic cycle
d) Understand how nationalised industries may have different objectives from private sector businesses

5/ State-owned businesses - such as the Royal Mail, Network Rail or Northern Rock may be given objectives that are not geared to maximising commercial returns. Network Rail for example is a “not-for-dividend” company, which means that all of its profits are invested in the railway network.