Business Objectives (Edexcel A Level Economics A)

Profit & Revenue Maximisation

Profit Maximisation

• Most firms have the rational business objective of profit maximisation

  • Profits benefit shareholders as they receive dividends & also increase the underlying share price

    • An increase in the underlying share price increases the wealth of the shareholder

• To achieve profit maximisation firms, follow the profit maximisation rule

  • When marginal cost (MC) = marginal revenue (MR) then no additional profit can be extracted by producing another unit of output

  • When MC < MR additional profit can still be extracted by producing an additional unit of output

  • When MC > MR the firm has gone beyond the profit maximisation level of output

    • It is making a marginal loss on each unit produced beyond the point where MC = MR

• In reality, firms may find it difficult to produce at the profit maximisation level of output

  • They may not know where this level is

  • In the short term they may not adjust their prices if the marginal cost changes

    • Marginal costs can change regularly and regular price changes would be disruptive to customers

  • In the long-term firms will seek to adjust prices to the profit maximisation level of output

  • Firms may be forced to change prices by the Competition Commission

    • The profit maximisation level of output often results in high prices for consumers

    • Changing prices changes the marginal revenue

Diagram analysis

• This firm has market power as the MR and average revenue (AR) curve are downward sloping

• At the profit maximisation level of output (MC = MR)

  • The selling price is P₁

  • The average cost is C₁

  • The supernormal profit =

Revenue Maximisation

• Some firms have the business objective of revenue maximisation

  • This often occurs due to the principal agent problem

    • Sales managers often receive commission on sales as part of their wages and this incentivises them to maximise sales

    • Profit maximisation for shareholders becomes a secondary objective for the sales managers

  • Firms will also maximise revenue in order to increase output & benefit from economies of scale

  • In the short-term firms may use this strategy to eliminate the competition as the price is lower than when focussing on profit maximisation

• To achieve revenue maximisation firms produce up to the level of output where MR = 0

  • When MR > 0, producing another unit of output will increase total revenue

Diagram analysis

• This firm has market power as the MR and average revenue (AR) curve are downward sloping

• At the revenue maximisation level of output (MR = 0)

  • The selling price is P₁

  • The average cost is C₁

  • The supernormal profit =

  • The supernormal profit is less than when the firm follows the profit maximisation rule

Sales Maximisation & Satisficing

Sales Maximisation

• Some firms have the business objective of sales maximisation

  • This occurs at the level of output where AC = AR (normal profit/breakeven)

  • In the short-term firms may use this strategy to clear stock during a sale

    • They sell remaining stock without making a loss per unit

Diagram analysis

• This firm has market power as the MR and average revenue (AR) curve are downward sloping

• At the sales maximisation level of output (AC = AR)

  • The selling price is P₁

  • The average cost is also at P₁

  • The firm is breaking even (normal profit)

Satisficing

• Some firms have the business objective of satisficing

• This often occurs as a result of the principal agent problem

  • Rationally, managers know shareholders want to profit maximise

  • Rationally, managers want to maximise sales or revenue so as to increase their wages

  • Managers (who control the business) settle for a level of output somewhere between profit and sales maximisation

    • This increases their wages and reduces potential conflict with shareholders