Contents
Diagram for different business objectives
We can use a cost-revenue diagram to show different business objectives:
- Profit maximisation: MR = MC.
- This occurs where marginal revenue equals marginal cost (MR = MC).
- If MR > MC, then a small increase in output increases profits. If MR < MC, a small decrease in output increases profits.
- MR = MC occurs at output level q.
- Dotting up to the average revenue line (average revenue is the price), we find the profit-maximising price p.
- Revenue maximisation: MR=0.
- This occurs where marginal revenue equals zero (MR=0).
- If MR > 0, the firm can increase revenue by increasing output. If MR < 0, a small decrease in output leads to higher revenue.
- The revenue maximising outcome is at output level q1 and price p1.
- Sales maximisation: AR = ATC.
- This occurs where average revenue equals average total cost.
- The sales maximising outcome is at output level q2 and price p2.
Different business objectives and reasons for them
Reasons for maximising profits
- Shareholder benefit from higher dividend payments from profits.
- This could encourage buying of shares or further investment into company, as shareholders seek dividends as returns on their investment.
- Reduces the risk of firm failure.
- The firm is as far from its long run shutdown point (AR = ATC) as possible.
- It can also allow firms to build a financial reserve of retained profits in case of a downturn or shock to the business.
- This enables firms the best chance of survival.
- The firm has more profit to invest back into the business.
- This allows the firm to be dynamically efficient.
- The firm can invest the profits to innovate, lowering production costs over time and increasing future profits.
- Alternatively the firm could invest in improving product quality. This would increase demand for the firm’s product, boosting AR and MR, leading to higher future profits.
- However, competition regulation may prevent firms increasing prices to maximise profits.
- Competition regulators could impose price caps to prevent firms raising prices.
- Firms may face fines if they exceed a price cap.
- Raising prices in general too much could trigger intervention from competition regulators.
- This could limit the extent to which firms can maximise profits in practice.
Reasons for maximising sales
- Economies of scale.
- Maximising sales increases firm size.
- This can lead to lower long-run average cost as output increases.
- For example, a firm can use its larger size to bulk-buy inputs at a discount per unit.
- However if the firm grows too large, there can be diseconomies of scale. This could include bureaucracy in a large firm or challenes in coordinating different teams within a large firm. This drives up LRAC.
- To achieve a high market share and acquire monopoly power.
- By maximising sales, the firm’s market share grows.
- This can lead to the firm acquiring monopoly power.
- This is beneficial for the firm. At some point in the future, the firm can switch from sales max to profit max, increasing the price and making large supernormal profits.
- However regulation may prevent firms from raising prices in the future or becoming too large. Competition regulators could choose to put in place price caps or break up large firms.
- Not only does such regulation disincentivise firm growth due to the risk of the firm breaking up. Regulation also prevents firms from abusing monopoly power in the future.
- The principal agent problem.
- The owners / shareholders of the firm (also known as the ‘principals’) and the manager (also known as the ‘agent’) are often different people.
- The owners or shareholders may aim to maximise profits.
- However the manager may aim for other objectives, such as maximising sales.
- The manager may care about the reputation of the firm (and by extension the manager’s own reputation).
- The manager may also care about office perks, such as a large private office or having lots of staff reporting to them.
- Either way, the objectives of the manager and the owner are not aligned. The firm ends up maximising sales, even though owners would prefer profit maximisation.
- However owners can include bonuses for high profits in the manager’s contract. Another option is to include shares in the company as part of the contract. This can incentivise the manager to maximise profits.
- Also, shareholders can hold senior managers to account at annual general meetings (AGM). This includes voting on the manager’s pay package. This could incentivise managers to maximise profits to ensure their pay package is approved.
- For some companies, the manager and the owner are the same person. For example, small family-run businesses. These businesses are less likely to suffer from the principal agent problem.
- Limit pricing.
- Firms may choose to produce where AR = ATC (sales maximising) to prevent other firms from entering.
- When there are zero supernormal profits in a market, there is less incentive for other firms to enter.
- This is called limit pricing. It allows a firm to maintain its high market share.
- This kind of strategy can also avoid the risk of intervention from competition authorities, as prices are lower than the profit-maximising price.
Reasons for maximising revenue
- Maintain cash flow
- Maximising revenue gives the firm a constant flow of cash into the business.
- This may help the firm to cover expenses, repay debt and invest into the business.
- This cash flow also reduces the risk of the firm failing to pay its bills because of a lack of cash (a “liquidity” issue is avoided).
- Attract investors by growing revenue
- A high revenue can signal to investors that there is high demand for the product.
- This can encourage investors to invest in the company, given the potential for future growth in the company due to the high demand for the product.
- The principal agent problem can also apply to revenue maximisation:
- While owners may aim to maximise profits, managers may aim for another objective.
- Specifically managers could aim for revenue maximisation. This could help improve the reputation of the manager.
- For more on the principal agent problem, see the section above on this (under sales maximisation).
Satisficing as a business objective
Satisficing is when the firm makes an acceptable level of supernormal profits, while trying to satisfy other stakeholders such as workers and consumers.
For example, a company could set a minimum level of profits or sales to achieve, rather than maximising profit or sales.
This reflects the fact that in practice, businesses may adopt a simple profit or sales goal, rather than maximising a given objective.
A satisficing firm may set the price at p* in the diagram below. This is set below the profit-maximising price, while enabling the firm to make some supernormal profit.
This enables the firm to pay some dividends to its shareholders.
But profit satisficing also lowers the price of the good compared to profit maximisation, increasing consumer surplus.
Instead of firms maximising profits, firms can pay employees higher wages, or protect the environment.
Consideration of laws on environment, workers’ rights and competition policy may encourage the firm to satisfice instead of maximising profits.
The principal agent problem may also lead to satisficing.
Practice exam question written in the style of Edexcel Economics A
This question features a short extract followed by a practice question.
A firm like Apple could be viewed as maximising profit. In February 2025, Apple pays $0.25 per share in dividends per quarter. The CEO of Apple, Tim Cook is awarded £45 million in target compensation for 2023, which is mostly from shares. Apple has used some profits to reinvest. For example, it has improved its chips, with the new M2 Pro and M2 Max, as well as software features.
Question: Evaluate the reasons why firms may maximise profits. (15 marks)
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