Profit-Maximising Objective of Firms
Profit maximisation is the traditional objective of a firm. It occurs when a firm produces the level of output that creates the greatest possible difference between total revenue and total cost.
Formula:
Profit=Total Revenue−Total Cost
Where:
→ Total Revenue (TR) = Price × Quantity sold
→ Total Cost (TC) = Total fixed costs + Total variable costs
How Does a Firm Maximise Profit?
A firm maximises profit by comparing its marginal revenue with its marginal cost.
→ Marginal Revenue (MR) is the additional revenue earned from selling one extra unit.
→ Marginal Cost (MC) is the additional cost of producing one extra unit.
→ If MR is greater than MC, producing another unit adds more to revenue than to cost, so profit increases.
→ If MR is less than MC, producing another unit adds more to cost than to revenue, so profit decreases.
→ Profit is maximised at the output where MR = MC, provided marginal cost crosses marginal revenue from below and the relevant conditions for a maximum are satisfied.
Example:
A firm sells notebooks. Producing one additional notebook adds ₹50 to revenue and ₹35 to cost.
→ Additional revenue = ₹50
→ Additional cost = ₹35
→ Additional profit = ₹15
The firm should increase production if this additional unit can be sold and no other relevant constraint changes.
However, if the next notebook adds ₹30 to revenue but ₹40 to cost, producing it reduces profit by ₹10.
Why Do Firms Aim to Maximise Profit?
→ Rewards owners: Higher profit can provide greater returns to shareholders through dividends.
→ Finance expansion: Retained profits can be used to purchase machinery, open branches or develop new products.
→ Attract investors: Investors may be more willing to provide finance to a profitable business.
→ Improve survival: Profits provide a financial cushion during periods of falling demand or rising costs.
→ Encourage efficiency: The objective encourages firms to control costs and use resources effectively.
Limitations of Profit Maximisation
→ Managers may have objectives that conflict with maximising profit.
→ A firm may prioritise survival during an economic downturn rather than maximising short-term profit.
→ Maximising current profit may involve cutting training, research or maintenance, which can damage long-term performance.
→ Firms may face uncertainty about future demand, costs and competitors’ actions.
→ Shareholders may prefer sustainable long-term profit rather than the highest possible profit in one period.
Other Objectives of Firms
Firms do not always aim to maximise profit. Their objectives may change according to their size, ownership, market conditions and stage of development.
Survival
Survival means ensuring that a firm continues operating rather than closing down.
This objective is especially important for new firms, firms facing strong competition and businesses experiencing an economic downturn.
Why might a firm prioritise survival?
→ Demand may fall, reducing sales revenue.
→ Rising costs may reduce profit or create losses.
→ New competitors may take away customers.
→ The firm may have limited cash reserves and difficulty obtaining finance.
→ The owners may accept lower profits or temporary losses to keep the business operating.
Example: A small restaurant reduces its prices and operating hours during a period of weak demand to reduce costs and retain customers.
Advantages
→ The firm may retain its customers, employees and suppliers.
→ It gets more time to improve its products or reduce costs.
→ It may recover when market conditions improve.
Disadvantages
→ Lower prices may reduce profit margins.
→ Cutting costs too much may reduce product quality.
→ Continuing to operate with persistent losses may eventually exhaust the firm’s funds.
Profit Satisficing
Profit satisficing occurs when a firm aims to earn a satisfactory or acceptable level of profit rather than the maximum possible profit.
This objective may arise when managers have other priorities or when shareholders are satisfied with a reasonable return.
Example: A business could increase profit by opening several new branches, but its owners decide to operate fewer branches to maintain a manageable workload while earning sufficient profit.
Advantages
→ Owners receive an acceptable return.
→ Managers may have less pressure to maximise profit at all costs.
→ The firm may maintain employee welfare, product quality and a manageable size.
Disadvantages
→ The firm may miss opportunities to earn higher profits.
→ Competitors that maximise profit may expand more quickly.
→ It may be difficult to determine what level of profit is truly satisfactory.
Important distinction: Profit satisficing means earning enough profit to meet an acceptable target, not deliberately making a loss.
Sales Maximisation
Sales maximisation occurs when a firm aims to maximise the quantity of goods sold or its sales revenue, depending on how the objective is defined.
In many economics contexts, sales maximisation refers to maximising total sales revenue. It is important to distinguish this from revenue maximisation, which specifically focuses on the highest possible total revenue.
Why might a firm aim to maximise sales?
→ Higher sales may increase market share.
→ More customers may become familiar with the brand.
→ Higher sales volume may allow the firm to benefit from economies of scale.
→ A larger customer base may make it easier to introduce new products.
→ Managers may receive rewards linked to sales performance.
Example: A mobile phone company offers discounts to increase the number of phones sold and gain market share.
Advantages
→ The firm may build brand awareness and customer loyalty.
→ Higher output may reduce average costs if economies of scale are available.
→ A larger market share may strengthen the firm’s position against competitors.
Disadvantages
→ Discounts may reduce the profit earned per unit.
→ Additional advertising and distribution may increase costs.
→ Higher sales do not necessarily mean higher profit.
→ A firm may expand sales beyond a level that maximises profit.
Revenue Maximisation
Revenue maximisation occurs when a firm aims to achieve the highest possible total revenue, without necessarily maximising profit.
Formula:
TR=P×Q
Where:
→ TR = Total revenue
→ P = Price per unit
→ Q = Quantity sold
Revenue maximisation occurs where marginal revenue equals zero, provided total revenue reaches a maximum at that point.
Example:
A firm sells 100 units at ₹100 each.
→ Total revenue = ₹100 × 100 = ₹10,000.
The firm reduces its price to ₹90 and sells 120 units.
→ Total revenue = ₹90 × 120 = ₹10,800.
Revenue has increased even though the price has fallen.
However, whether profit has increased depends on how costs change.
Advantages
→ Higher revenue may help the firm increase market share.
→ It may improve the firm’s ability to attract finance.
→ Greater sales volume may create opportunities for economies of scale.
Disadvantages
→ Higher revenue does not guarantee higher profit.
→ Increasing sales may require substantial advertising, discounts and distribution costs.
→ The firm may produce beyond its profit-maximising output.
Comparison of Firm Objectives
| Objective | Main aim | Example |
|---|---|---|
| Profit maximisation | Highest possible profit | Choosing output where MR = MC |
| Survival | Continue operating | Cutting costs during a downturn |
| Profit satisficing | Earn an acceptable profit | Maintaining a manageable business size |
| Sales maximisation | Maximise sales, often revenue or volume | Discounts to gain customers |
| Revenue maximisation | Highest possible total revenue | Choosing output where MR = 0 |
Exam tip: When explaining a firm’s objective, identify the objective first, then explain the decisions the firm would make to achieve it. Do not assume that increasing sales or revenue automatically increases profit.
Price Discrimination
Price discrimination occurs when a firm charges different prices to different customers for the same good or service, where the price differences are not explained by differences in the cost of supplying those customers.
It is often used by firms with some market power.
Example: A cinema charges different ticket prices to adults and students for the same screening, even though the cost of showing the film to each customer is essentially the same.
Conditions for Effective Price Discrimination
1. Market power
→ The firm needs some control over its price.
→ A firm in perfect competition generally cannot charge different prices successfully because customers can buy from competing sellers at the market price.
2. Ability to separate customers
→ The firm must be able to identify different groups of customers or distinguish between individual customers.
→ It may use age, student status, location, booking time or purchase quantity.
3. Different price elasticities of demand
→ Customers must respond differently to price changes.
→ Customers with relatively inelastic demand may be charged a higher price.
→ Customers with relatively elastic demand may be charged a lower price to encourage purchases.
4. Prevention of resale
→ Customers paying a lower price must not be able to resell the product to customers who would otherwise pay a higher price.
→ For example, discounted student tickets may require valid student identification.
5. Different willingness to pay
→ Different customers must be willing or able to pay different prices.
→ The firm can then increase revenue by charging prices that reflect these differences.
First-Degree Price Discrimination
First-degree price discrimination occurs when a firm charges each customer the maximum price that the customer is willing to pay for each unit.
It is also known as perfect price discrimination.
Example: A seller negotiates a different price with each buyer based on the maximum amount each buyer is willing to pay.
How it works
→ The firm identifies each customer’s willingness to pay.
→ Customers who are willing to pay more are charged more.
→ Customers who are willing to pay less are charged less.
→ The firm captures the consumer surplus that customers would otherwise retain, to the extent that it can identify and charge their maximum willingness to pay.
Consequences
→ The firm may earn higher revenue and profit.
→ Consumer surplus may fall to zero for the units sold under perfect discrimination.
→ More units may be sold than under a single-price monopoly.
→ Under the standard model, output can reach the allocatively efficient level if the firm sells every unit for which willingness to pay is at least marginal cost.
Limitations
→ The firm needs detailed information about each customer’s willingness to pay.
→ Customers may be unwilling to reveal how much they can afford.
→ Negotiating individual prices can be costly and time-consuming.
Second-Degree Price Discrimination
Second-degree price discrimination occurs when the price per unit varies according to the quantity purchased or the version of the product chosen, rather than the customer being directly charged an individually negotiated price.
Examples:
→ Bulk discounts for buying larger quantities.
→ Electricity tariffs with different prices for different usage blocks.
→ Software plans offering different levels of features.
How it works
→ Customers select the pricing option that suits their needs.
→ Those who buy more or choose a particular version may pay a different price per unit or in total.
→ The firm encourages customers to reveal their preferences through their purchasing choices.
Advantages
→ Bulk purchases may increase sales volume.
→ The firm may attract customers with different willingness to pay.
→ Higher sales may help spread fixed costs across more units.
Disadvantages
→ Customers may switch to cheaper purchasing options, reducing the revenue earned from some sales.
→ Complex pricing plans may confuse customers.
→ Discounts may reduce profit if the extra sales do not compensate for the lower price.
Third-Degree Price Discrimination
Third-degree price discrimination occurs when a firm divides customers into separate identifiable groups and charges each group a different price for the same product or service.
Examples:
→ Student discounts at cinemas.
→ Lower fares for eligible senior citizens.
→ Different prices for the same service in different geographical markets, where resale between markets can be prevented.
How it works
→ The firm identifies different customer groups.
→ It estimates the price elasticity of demand in each group.
→ A higher price is generally charged to the group with more inelastic demand.
→ A lower price is generally charged to the group with more elastic demand.
Example: A transport company charges business travellers a higher fare than leisure travellers when business travellers are less sensitive to price and the company can prevent customers from switching between fare categories.
Advantages
→ The firm may earn higher total revenue and profit.
→ Customers with lower willingness to pay may gain access to the product.
→ Capacity that would otherwise remain unused may be sold at a lower price.
Disadvantages
→ Customers in the high-price group may pay substantially more.
→ Some customers may be excluded if prices are too high.
→ Identifying and separating groups may create administrative costs.
→ Customers may perceive the pricing as unfair.
Comparison of the Three Degrees
| Degree | Basis of different prices | Example |
|---|---|---|
| First degree | Each customer’s maximum willingness to pay | Individually negotiated prices |
| Second degree | Quantity purchased or product version selected | Bulk discounts |
| Third degree | Identifiable customer groups | Student discounts |
Overall Consequences of Price Discrimination
For firms
→ Revenue and profit may increase.
→ Different customer groups can be served more effectively.
→ Greater output may allow the firm to use spare capacity.
→ The firm may incur costs to identify groups and prevent resale.
For consumers
→ Some customers gain access through lower prices.
→ Other customers may pay higher prices.
→ Consumer surplus may fall for customers charged higher prices.
→ Access to a product may increase if lower prices bring more customers into the market.
For society
→ Price discrimination may increase output and improve the use of resources in some circumstances.
→ It may also transfer surplus from consumers to producers.
→ Its effect on overall welfare depends on the pricing method, costs, output and market conditions.
Other Pricing Policies
Firms may use pricing strategies to protect market share, discourage competitors or respond to the pricing decisions of rival businesses.
Limit Pricing
Limit pricing occurs when an established firm sets a relatively low price to discourage potential competitors from entering the market.
The price is intended to make entry less attractive because a new firm may expect insufficient profit to justify the cost of entering.
Example: An established firm sets a price that allows it to earn a profit but leaves a potential entrant expecting only a small return after covering its costs.
How it works
→ The established firm charges a price low enough to reduce the expected profitability of entry.
→ Potential competitors estimate the revenue and costs they would face.
→ If expected profit is too low, they may decide not to enter.
→ The established firm may retain its market share and market power.
Advantages
→ May discourage new competition.
→ May help protect the firm’s long-term market position.
→ Consumers may benefit from lower prices than they would face if the firm charged a higher price.
Disadvantages
→ Lower prices may reduce the established firm’s profit.
→ If the firm misjudges demand or costs, the strategy may be unsuccessful.
→ A new firm with lower costs or a strong competitive advantage may still enter.
Predatory Pricing
Predatory pricing occurs when a firm deliberately sets prices very low, often below an appropriate measure of cost, with the intention of forcing competitors out of the market or deterring them from competing.
The firm may aim to raise prices later after competition has weakened.
Example: A large firm temporarily sells a product at a price that its smaller competitors cannot sustain, hoping they will leave the market.
How it works
→ The firm cuts prices sharply.
→ Competitors may suffer losses and reduce output or leave the market.
→ If the strategy succeeds, the firm faces less competition.
→ The firm may subsequently raise prices to recover its earlier losses.
Advantages for the firm if successful
→ Competitors may leave the market.
→ The firm may gain market share.
→ It may strengthen its market power in the long run.
Disadvantages and risks
→ The firm may incur substantial losses during the low-price period.
→ Competitors may have sufficient finance to survive.
→ New competitors may enter if prices rise again.
→ Consumers may face higher prices and less choice after competition weakens.
→ Predatory pricing may breach competition law, depending on the jurisdiction and circumstances.
Limit pricing vs predatory pricing
→ Limit pricing: A relatively low price is used mainly to discourage entry by potential competitors.
→ Predatory pricing: Very low pricing is used with the intention of driving existing competitors out or weakening them.
Price Leadership
Price leadership occurs when one firm, often a dominant firm in an oligopoly, sets a price that other firms in the market follow.
The leading firm may have a large market share, lower costs or a reputation for influencing market conditions.
Example: A major airline changes its fares and rival airlines respond by changing their own fares.
How it works
→ The leading firm announces or changes its price.
→ Other firms observe the decision.
→ They may follow the price change to avoid losing customers or to maintain their own margins.
→ The market price may become relatively stable when firms repeatedly follow the leader.
Advantages
→ Firms may avoid frequent price changes.
→ Pricing decisions may become more predictable.
→ Firms may reduce the risk of a prolonged price war.
Disadvantages
→ The leading firm may have considerable influence over market prices.
→ Prices may remain higher than under more competitive conditions.
→ Smaller firms may have limited freedom to set prices independently.
→ If firms coordinate prices unlawfully, the behaviour may raise competition-law concerns. Price leadership by itself does not necessarily mean that firms have colluded.
Relationship Between Price Elasticity of Demand and a Firm’s Revenue
Total revenue depends on both the price charged and the quantity sold.
TR=P×Q
When a firm changes its price, the quantity demanded usually changes in the opposite direction along a normal downward-sloping demand curve.
The effect on total revenue depends on the price elasticity of demand (PED).
PED=% change in price% change in quantity demanded
For classification, PED is often discussed using its absolute value.
- Elastic demand: ∣PED∣>1
- Unitary elastic demand: ∣PED∣=1
- Inelastic demand: ∣PED∣<1
When Demand Is Elastic
Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price.
If price falls:
→ Quantity demanded rises by a larger percentage.
→ The increase in quantity sold more than compensates for the lower price.
→ Total revenue increases.
If price rises:
→ Quantity demanded falls by a larger percentage.
→ The fall in quantity sold more than offsets the higher price.
→ Total revenue decreases.
Example: A firm reduces the price of a product by 10%, causing quantity demanded to rise by 20%. Total revenue increases because the percentage rise in quantity is greater than the percentage fall in price.
When Demand Is Inelastic
Demand is inelastic when the percentage change in quantity demanded is smaller than the percentage change in price.
If price falls:
→ Quantity demanded rises by a smaller percentage.
→ The increase in quantity sold is insufficient to compensate for the lower price.
→ Total revenue decreases.
If price rises:
→ Quantity demanded falls by a smaller percentage.
→ The higher price more than compensates for the fall in quantity sold.
→ Total revenue increases.
Example: A firm increases its price by 10%, and quantity demanded falls by only 3%. Total revenue increases because the percentage rise in price exceeds the percentage fall in quantity.
When Demand Is Unitary Elastic
Demand is unitary elastic when the percentage change in quantity demanded equals the percentage change in price in absolute terms.
→ A price fall is matched by an equal percentage rise in quantity demanded.
→ A price rise is matched by an equal percentage fall in quantity demanded.
→ Along a demand curve where PED is unitary at the relevant point, total revenue is at its maximum.
Summary: Price Changes and Total Revenue
| Type of demand | Price falls | Price rises |
|---|---|---|
| Elastic | Total revenue rises | Total revenue falls |
| Unitary elastic | Total revenue remains unchanged for an infinitesimal change at that point | Total revenue remains unchanged for an infinitesimal change at that point |
| Inelastic | Total revenue falls | Total revenue rises |
For finite price changes, exact revenue calculations are the safest method. The standard table expresses the usual relationship between price changes and revenue along a normal downward-sloping demand curve.
Calculating the Change in Total Revenue
Example 1: Price falls and demand is elastic
Initial position:
→ Price = ₹100
→ Quantity sold = 100 units
→ TR = ₹100 × 100 = ₹10,000
New position:
→ Price = ₹90
→ Quantity sold = 130 units
→ TR = ₹90 × 130 = ₹11,700
Therefore, total revenue increases by ₹1,700.
Example 2: Price rises and demand is inelastic
Initial position:
→ Price = ₹100
→ Quantity sold = 100 units
→ TR = ₹10,000
New position:
→ Price = ₹110
→ Quantity sold = 95 units
→ TR = ₹110 × 95 = ₹10,450
Therefore, total revenue increases by ₹450.
Exam tip: Always calculate total revenue before and after the price change when numerical data is given. Do not rely on PED labels alone if the question provides exact prices and quantities.
Revenue and the Kinked Demand Curve
A kinked demand curve is a model used to explain price rigidity in an oligopoly, where firms are interdependent and consider how rivals might respond to price changes.
It is based on two assumptions:
→ If one firm raises its price, rival firms are unlikely to follow. Customers may switch to competitors, so the firm loses a relatively large amount of sales.
→ If one firm lowers its price, rival firms are likely to follow. The firm gains relatively few additional customers because competitors also lower their prices.
These assumptions produce two different sections of the firm’s demand curve.
Above the Kink
The demand curve above the kink is relatively elastic.
→ The firm raises its price.
→ Competitors do not follow the increase.
→ Customers switch to competitors.
→ Quantity demanded falls by a relatively large percentage.
→ Total revenue falls.
Below the Kink
The demand curve below the kink is relatively inelastic.
→ The firm reduces its price.
→ Competitors follow the price reduction.
→ The firm gains relatively few additional customers.
→ Quantity demanded rises by a relatively small percentage.
→ Total revenue falls.
Why Might Prices Remain Rigid?
→ Raising prices may cause a large loss of customers.
→ Cutting prices may produce little extra sales if competitors follow.
→ Firms may therefore have little incentive to change their prices.
→ This helps explain why prices in some oligopolistic markets remain stable even when costs change moderately.
The Marginal Revenue Gap
At the kink in the demand curve, the marginal revenue curve has a discontinuity or gap.
→ Marginal revenue differs above and below the kink because the demand curve has different elasticities on its two sections.
→ If marginal cost changes within the vertical gap in the marginal revenue curve, the profit-maximising output and price may remain unchanged.
→ This provides an explanation for price rigidity in an oligopoly.
Important limitation: The kinked demand curve is a model based on assumptions about competitors’ behaviour. It does not prove that every oligopoly will keep prices constant, and it does not explain how the original market price was established.