Differing objectives and policies of firms

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

The traditional view is that firms aim for maximum profit, which is found where MC = MR. Real firms may have other aims: survival in hard times, the highest possible revenue, the highest possible sales, or a profit that is just enough to keep shareholders content (profit satisficing).

A firm with market power can use price discrimination: charging different prices for the same product for reasons not linked to cost. It can also price low to keep rivals out or drive them out.

In the kinked demand curve model of oligopoly, rivals follow a price cut but not a price rise. Demand is elastic above the present price and inelastic below it, so prices tend to stay the same.

Rules to remember

Profit maximisation: MC = MR, with MC rising. Revenue maximisation: MR = 0. Sales maximisation: the largest output where AR = AC (normal profit).
First degree: each buyer pays the most they are willing to pay. Second degree: price depends on the quantity bought. Third degree: different prices for different groups of buyers.
Conditions for price discrimination: market power, separate markets with different price elasticities, no resale between them.
With third-degree discrimination the higher price is set in the market with the less elastic demand.
Limit pricing: a price low enough to deter entry. Predatory pricing: a price below cost to drive rivals out. Price leadership: other firms follow one firm’s price changes.
Elastic demand: a price cut raises total revenue and MR is positive. Inelastic demand: a price cut lowers total revenue and MR is negative. Total revenue is highest where elasticity is 1.
Kinked demand curve: MR has a vertical gap at the kink. If MC shifts within the gap, price and output do not change.

Common mistake

Students say profit is maximised where revenue is highest. Revenue is highest where MR = 0. Profit is highest where MR = MC, which is at a lower output when MC is positive.

Worked example

A firm cuts its price from $10 to $8 and its weekly sales rise from 100 to 140 units. What happens to total revenue, what is the marginal revenue of each extra unit, and is demand elastic or inelastic?

Total revenue before = 10 × 100 = $1000. After = 8 × 140 = $1120.
Marginal revenue = change in TR ÷ change in quantity = 120 ÷ 40 = $3 per unit.
A price cut raised total revenue and MR is positive, so demand is price elastic over this range.

Answer: Total revenue rises by $120, marginal revenue is $3 per unit and demand is elastic.

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