Business Objectives (DP IB Economics)
Revision Note
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 regulators in their country (especially natural monopolies)
The profit maximisation level of output often results in high prices for consumers
Changing prices changes the marginal revenue
The profit maximisation level of output occurs at Q1 where MC = MR resulting in a market price of P1
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 =
Examiner Tip
Profit maximisation is all about the quantity of output.
To determine the level of profit:
identify where MC = MR and then extend the dotted line upwards to the point where it hits the AR curve - this is your selling price
Where this line crosses the average cost curve (AC) represents the cost per unit at this level of output
The profit is the difference between the selling price and the average cost
Evaluating Profit Maximisation as a Business Objective
Apart from the very significant advantages that are offered by pursuing profit maximisation, there are some distinct disadvantages too
The Advantages & Disadvantages of Pursuing Profit Maximisation
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Growth
Some firms have the business objective of growth
Firms with a growth objective often focus on increasing their sales revenue or market share
Firms will also maximise revenue in order to increase output & benefit from economies of scale
A growing firm is less likely to fail
1. Revenue Maximisation as a Sign of Growth
Firms aim to 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
The revenue maximisation level of output occurs at Q1 where MR = 0 resulting in a market price of P1
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
2. Market Share as a sign of Growth
Some firms have the business objective of sales maximisation which further lowers prices and has the potential to increases market share
Sales maximisation 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 or increase market share
Firms sell remaining stock without making a loss per unit
The sales maximisation level of output occurs at Q1 where AC = AR resulting in a market price of P1
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)
Examiner Tip
Although sales and revenue maximisation are not in the syllabus per se, due to the fat they can form part of the growth objective, it would be useful to understand them. Revenue maximisation was also examined in the May 2023 session.
Evaluating Growth as a Corporate Objective
Companies need to carefully assess the trade-offs and consider a balanced approach to growth, taking into account risk management, organisational capabilities, and long-term sustainability of any growth actions
The Advantages & Disadvantages of Pursuing Growth
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Satisficing
Satisficing refers to the pursuit of satisfactory or acceptable outcomes rather than profit maximisation
It is a decision-making approach where businesses aim to meet a minimum threshold or standard of performance rather than striving for the absolute best outcome
Small firms may satisfice around the desires of the business owner (sole trader) to have more well-being in their life
Many large firms often end up satisficing as a result of the principal agent problem
Rationally, managers know shareholders want to profit maximise
However, 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
Evaluating Satisficing as a Corporate Objective
Balancing the advantages and disadvantages of satisficing is essential, and companies may adopt a combination of satisficing and profit or growth strategies to achieve the best possible outcomes
The Advantages & Disadvantages of Pursuing Satisficing
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Corporate Social Responsibility (CSR)
Corporate social responsibility involved conducting business activity in an ethical way and balancing the interests of shareholders with those of the wider community
Examples of Corporate Socially Responsible Activities
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Sustainable sourcing of raw materials and components |
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Responsible marketing |
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Protecting the environment |
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Responsible customer service |
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It is now common practice for large companies to publish annual Corporate Responsibility Reports which provide an audit of the steps being taken to meet their commitments to a range of stakeholders alongside annual financial reports
Extra costs are involved in operating in a socially responsible way and these costs must be passed on to consumers
The Advantages of CSR Objectives
CSR can enhance the business image and reputation
CSR is attractive to many stakeholders
CSR can be very profitable as it adds value for many stakeholders
CSR may improve employee motivation and productivity
CSR can help to recruit strong candidates for jobs advertised
CSR may help to solve social problems e.g. resource depletion
The Disadvantages of CSR Objectives
CSR goals can involve significant financial and resource commitments which can divert funds and attention away from other business priorities
CSR goals means facing increased expectations from stakeholders, including customers, employees, investors, and the general public
Defining and measuring the impact of CSR initiatives can be challenging as it may be difficult to establish clear metrics and demonstrate tangible results
Adopting CSR goals without genuine commitment and meaningful action can lead to accusations of greenwashing or socialwashing
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