7.8 Differing objectives and policies of firms
- Syllabus
- 9708–2026–2027
- Topic
- 7.8
- Level
- A2
Learning objectives
7.8.1Profit maximisation• Traditional profit-maximising objective of firms7.8.2Alternative firm objectives• An understanding of other objectives of firms:- survival- profit satisficing- sales maximisation- revenue maximisation7.8.3Price discrimination• Price discrimination - first, second and third degree:- conditions for effective price discrimination- consequences of price discrimination7.8.4Pricing policies• Other pricing policies:- limit pricing- predatory pricing- price leadership7.8.5PED and firm revenue• Relationship between price elasticity of demand and a firm's revenue:- in a normal downward sloping demand curve- in a kinked demand curve
A firm maximises profit where the extra revenue from output equals the extra cost
Profit is maximised at the output where marginal revenue equals marginal cost, MR=MC, provided marginal cost is rising through the intersection and the firm covers the relevant avoidable cost in the short run.
If MR exceeds MC, one more unit adds to profit; if MC exceeds MR, reducing output raises profit. The firm then reads price or average revenue from its demand conditions and compares total revenue with total cost.
At 100 units MR=12andMC=9, expanding is profitable at the margin. At 105 units MR=10andMC=10, the firm stops if MC is rising beyond the intersection.
MR=MC identifies the best output, not automatically a positive profit; a firm may still minimise loss or shut down if revenue cannot cover avoidable cost.
Each alternative objective has a different output rule
| Objective | Decision rule | Typical reason or consequence |
|---|---|---|
| Survival | Keep liquidity and remain operating: cover AVC/avoidable cost in the short run and all AC in the long run | Recession, new firm, intense rivalry; accepts lower current profit |
| Profit satisficing | Earn a minimum acceptable profit rather than the maximum | Managers balance owner return with growth, security, staff or personal objectives |
| Revenue maximisation | Choose output where MR=0 and TR is highest | Usually higher Q and lower P than profit maximisation, while profit may remain positive |
| Sales-volume maximisation | Produce the largest Q consistent with a constraint, commonly at least normal profit where AR=AC | Builds market share, manager status, entry deterrence or network effects; usually still higher Q/lower P |
On a standard downward demand/cost diagram, profit-maximising output is MR=MC; revenue-maximising output is further right at MR=0; sales maximisation subject to normal profit is further right again at the relevant AR=AC point. Read price from AR at each output.
Changing from profit to revenue or sales maximisation normally transfers some producer surplus to consumers through lower price and more output, but can reduce shareholder profit and may move output away from allocative efficiency. The exact result depends on costs and the constraint.
Separated ownership and control can make growth, sales or satisficing attractive to managers. Active owners, profit-related pay and takeover threats can pull decisions back toward profit.
Revenue maximisation is not sales-volume maximisation: MR=0 maximises dollars of revenue, while sales maximisation pushes physical output as far as the profit constraint allows. Satisficing means acceptable profit, not maximum profit or automatic loss.
Price discrimination varies price by unit or customer, not supply cost
Price discrimination charges different prices for the same core product when the difference is not explained by marginal supply cost. The firm uses market power to capture different willingness to pay and must prevent effective resale/arbitrage.
| Degree | Pricing rule | Example/mechanism |
|---|---|---|
| First degree | Each unit/customer is charged the maximum willingness to pay | Perfect individual information captures almost all consumer surplus |
| Second degree | Price varies with quantity/block/version chosen, not customer identity | bulk blocks, two-part tariffs or menus induce self-selection |
| Third degree | Identifiable groups/markets pay different prices | student/adult, peak/off-peak, domestic/export; higher price in the less PED-elastic segment, other things equal |
Effective discrimination requires price-setting power; customers or purchases that can be identified/separated; different willingness to pay or PED; and little resale between low- and high-price markets. Third-degree profit allocation equates marginal revenue across segments to marginal cost, not the segment prices or PED values.
| Party/outcome | Possible effect |
|---|---|
| Producer | Higher revenue/profit and better capacity use if segmentation cost is covered |
| High-price consumers | Lose surplus and may buy less |
| Low-price consumers | Gain access at a price below a uniform monopoly price; output can expand |
| Society | Welfare can rise if extra output serves previously excluded buyers, or fall if discrimination mainly transfers surplus/restricts output; profit may finance dynamic efficiency but need not |
Non-transferable airline tickets sold cheaply months ahead and more expensively near departure can segment flexible travellers from urgent business demand. The result is discrimination only if cost differences do not explain the gap and resale is blocked.
Different quality, delivery cost or marginal service cost can justify different prices without discrimination. Third-degree groups must have different PED and be separable; identical PED gives no segmentation gain.
Strategic pricing targets entrants, incumbents or followers
| Policy | Target and method | Price/profit path | Conditions and risks |
|---|---|---|---|
| Limit pricing | Incumbent sets price low enough to make potential entry unattractive | Sacrifices some short-run profit for protected long-run profit; may price near AC/normal profit | Needs credible capacity/cost advantage and entry-sensitive rivals; low price can be costly |
| Predatory pricing | Firm prices very low, potentially below unit/avoidable cost, to force existing rivals to exit, then plans to raise price | Short-run price/profit fall; successful predator later raises price and recovers losses | Requires finance, barriers preventing re-entry and rivals unable to survive; often illegal/anti-competitive and hard to distinguish from competition |
| Price leadership | In oligopoly a dominant or recognised firm changes price and others follow | Coordinates/stabilises price without every firm independently selecting it | Requires interdependence and willingness to follow; may be tacit rather than explicit collusion |
Ask who is being influenced. Limit pricing deters a potential entrant before entry. Predatory pricing attacks a current rival and relies on later recoupment. Price leadership guides incumbent followers; it does not itself require below-cost price.
Consumers may gain temporarily from low limit or predatory prices, but long-run entry deterrence or rival exit can reduce choice and allow later higher prices. Price leadership can reduce uncertainty yet weaken independent price competition.
A low price is not enough to prove intent. Compare cost, duration, capacity, internal documents, rival entry/exit and whether later price increases can recoup losses. Aggressive efficient competition can also lower price.
Limit pricing protects a market from potential entry; predation aims to remove present competition. Price discrimination separates customers, not competitors, and price leadership belongs to oligopoly rather than pure monopoly.
PED determines how price changes move total revenue
PED = \frac{%\Delta Q_d}{%\Delta P}TR=P\times Q
| Absolute PED | Price cut | Price rise | MR/TR relation |
|---|---|---|---|
| >1 elastic | TR rises | TR falls | MR>0 while moving to greater Q |
| =1 unit elastic | TR unchanged at the margin | TR unchanged at the margin | MR=0 and TR is at its maximum on a normal downward curve |
| <1 inelastic | TR falls | TR rises | MR<0 while moving to greater Q |
A 10% price cut with a 20% quantity rise is elastic: new TR≈0.9P×1.2Q=1.08PQ, an 8% rise. With perfectly inelastic demand, quantity is unchanged, so a 5% price rise raises TR by 5%.
At an oligopoly's current kinked price, rivals are expected to ignore a price rise, so the firm's upper demand segment is relatively elastic and a rise cuts TR sharply. Rivals are expected to match a price cut, so the lower segment is relatively inelastic and a cut may reduce TR. This asymmetric response creates a discontinuous/vertical gap in MR; MC can move within the gap without changing the profit-maximising price and output.
The kinked-demand model explains price rigidity once a current price exists; it does not explain how that initial price was set and it does not mean price can never change. A large cost/demand shift or changed rival expectations can move the kink.
Use the absolute PED value for elastic/inelastic classification; the negative sign only records inverse direction. Revenue effects do not by themselves determine profit because cost may also change.