traditional profit-maximising objective of firms

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Traditional Profit‑Maximising Objective of Firms

1. Core definition

  • Profit (π) = Total Revenue (TR) – Total Cost (TC) π = TR – TC
  • The firm chooses the output level (Q) that maximises π.

2. Key assumptions (Cambridge syllabus 7.5)

  • Market structure: either price‑taking (perfect competition) or price‑setting (monopoly, monopolistic competition, oligopoly).
  • All factors of production are paid their marginal product (i.e. factor markets are competitive).
  • Perfect and complete information for buyers and sellers.
  • Profit is maximised over the relevant planning horizon – short‑run (some inputs fixed) or long‑run (all inputs variable).

3. Profit‑maximisation condition

  • Set marginal revenue (MR) equal to marginal cost (MC): MR = MC
  • If MR > MC → increase output (π rises).
    If MR < MC → reduce output (π rises).

4. Short‑run and long‑run decisions

4.1 Short‑run (at least one input fixed)

  • Shutdown rule: continue operating while P ≥ AVC (price covers average variable cost). If P < AVC the firm shuts down and incurs a loss equal to its fixed cost.
  • Profit outcomes:
    • Super‑normal (economic) profit: π > 0 (price > ATC).
    • Normal profit: π = 0. This is the minimum return required to cover the opportunity cost of capital and keep resources in the firm.
    • Sub‑normal (loss): π < 0 (price below ATC but above AVC).

4.2 Long‑run (all inputs variable)

  • Free entry and exit drive economic profit to zero: P = LRAC (price equals long‑run average cost).
  • Firms with LRAC below the market price earn super‑normal profit and attract entry; firms with LRAC above the price exit.
  • In the long‑run equilibrium all firms earn only normal profit.

5. Why firms may deviate from short‑run profit maximisation (syllabus 7.7)

  • Growth motives
    • Achieving economies of scale – higher output lowers LRAC, turning a short‑run loss into a long‑run profit.
    • Learning‑by‑doing – cumulative output reduces unit costs over time.
    • Market‑share expansion – accepting lower (or negative) short‑run profit to build a dominant position.
  • Survival motives
    • During a recession or intense competition a firm may produce as long as P ≥ AVC even if P < ATC, simply to stay in business.
  • Managerial satisficing
    • Managers set a target profit level and adjust output to meet it, rather than pushing output to the MR‑MC point.
  • Corporate Social Responsibility (CSR) / Social welfare
    • Firms may deliberately accept lower profit to achieve environmental, ethical or community objectives.
  • Strategic pricing motives (linked to 7.8)
    • Limit pricing – temporary low price to deter entry.
    • Predatory pricing – price below AVC to drive rivals out (illegal in many jurisdictions).
    • Price discrimination – charging different prices to different groups to fund a non‑profit objective or to increase overall profit.

6. Graphical illustration

MR‑MC diagram for a price‑setter (monopoly or monopolistic competition). The profit‑maximising output is where MR intersects MC; the vertical distance between price (P) and ATC at that output shows super‑normal profit.
Short‑run cost‑curve sketch (AFC, AVC, ATC, MC). The shutdown point is where AVC meets MC; the break‑even point is where ATC meets the price line.

7. Profit‑maximisation in different market structures (syllabus 7.6)

Market structure Demand faced by the firm How MR is derived Profit‑maximising rule Typical outcome (price, output, profit)
Perfect competition Perfectly elastic (horizontal) at market price P Because price is constant, MR = P Produce where P = MC (also MR = MC) In the long run P = MC = ATC → normal profit (π = 0)
Monopoly Downward‑sloping market demand Each extra unit lowers the price of all units sold; MR lies below demand and has twice the slope of the demand curve. Produce where MR = MC; charge the price that corresponds to this quantity on the demand curve. P > MC, P > ATC → super‑normal profit (unless regulated).
Monopolistic competition Downward‑sloping demand (more elastic than monopoly) Same method as monopoly – MR is below demand. Short‑run: MR = MC (π may be > 0).
Long‑run: entry drives demand down until P = ATC → normal profit.		 Long‑run price = ATC; output lower and price higher than in perfect competition.
Oligopoly – Cournot model Each firm faces the residual demand that remains after rivals’ output is taken into account. MR is derived from the residual‑demand function; it is flatter than the market demand. Each firm chooses Q where its own MR = MC, given the expected output of rivals. Outcome depends on the number of firms; can be between competitive and monopoly results.
Oligopoly – Kinked‑demand model Demand is relatively elastic for price increases and relatively inelastic for price decreases, creating a “kink”. Resulting MR curve is discontinuous at the kink. Firms tend to keep price at the kink; small changes in MC do not alter price or output. Price rigidity; profit may be normal or super‑normal depending on cost structure.

8. Alternative objectives of firms (syllabus 7.8)

Objective Key focus Decision rule Typical output/price implication Advantages (pros) Limitations (cons)
Profit maximisation Maximise π = TR – TC MR = MC Output where marginal profit is zero; price set by market structure. Ensures efficient allocation of resources; clear analytical rule. Ignores growth, market‑share, or social goals; may be too narrow for real‑world firms.
Revenue maximisation Maximise total revenue MR = 0 (operate on the elastic portion of demand) Higher output and lower price than profit maximisation; can generate a loss if costs are high. Useful when a firm wants to increase market presence quickly. May be unsustainable because costs can exceed revenue, leading to losses.
Market‑share (growth) maximisation Increase the firm’s share of the market Produce where P > MC to undercut rivals; profit target is secondary. Output above the MR‑MC point; price often below competitive equilibrium. Facilitates economies of scale, learning‑by‑doing, and future profitability. Short‑run losses are common; success depends on ability to sustain lower prices.
Survival (break‑even) objective Stay in operation during adverse periods Produce as long as P ≥ AVC (cover variable costs) Output may be below the profit‑maximising level; price set by market. Prevents liquidation and preserves the firm’s capital for future recovery. Does not generate profit; prolonged survival can erode capital.
Managerial satisficing Achieve an acceptable (target) level of profit Choose Q such that π meets a pre‑set target; adjust Q up or down accordingly. Output can be either higher or lower than the MR‑MC point, depending on the target. Reflects real‑world managerial behaviour and risk‑aversion. Lacks a precise optimisation rule; may leave profit on the table.
Corporate Social Responsibility (CSR) / Social‑welfare objective Balance profit with environmental, ethical or community goals Maximise a weighted function, e.g. απ + βW where W = social welfare. Output and price are chosen to reflect both profit and external‑benefit considerations. Improves reputation, can attract socially‑concerned consumers and investors. May reduce short‑run profitability; benefits are often difficult to quantify.

9. Pricing strategies linked to non‑profit‑maximising goals

  • Price discrimination – charging different prices to different consumer groups. It can raise total revenue (supporting profit‑maximisation) or fund a CSR initiative.
  • Limit pricing – setting a low price temporarily to make entry unattractive; short‑run profit is sacrificed for long‑run market power.
  • Predatory pricing – pricing below AVC to drive rivals out of the market; illegal in many jurisdictions but illustrates a survival/dominance motive.

10. Summary

The traditional profit‑maximising model provides a single analytical rule – MR = MC – that works across all market structures once the appropriate demand and marginal‑revenue curves are drawn. In the short run firms compare price with average variable cost to decide whether to operate; in the long run free entry and exit drive economic profit to zero. However, the Cambridge syllabus recognises that real‑world firms often pursue other objectives – growth, survival, managerial satisficing, or CSR – and may employ strategic pricing (price discrimination, limit pricing, predatory pricing) to achieve those aims. Understanding both the core profit‑maximising framework and its limitations is essential for answering the required AO1–AO3 exam questions.

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