JC Economics Essay Profit Maximisation & Alternatives Objectives Model Answers
For basic Market Structures topic, we assume profit maximisation in your “A” Levels H2 (and also H1) Economics. As you know, the profit levels can be supernormal (abnormal or economic profit), normal (or zero economic profit) or subnormal losses (economic losses).
In addition, do remember firms can have alternative forms of objectives. The following essay illustrates and explains
(a) Explain why firms in different markets attain different profit levels.
(b) Discuss the extent to which the profit objective of a firm determines its behaviour in the real world.
JC Economics Essay – Profit Maximisation & Profit Levels
Firms in different markets have different profit levels cos barriers of entry (BTE) vs non-barriers of entry in different mkts. Barriers to entry prevent new firms from entering a market. They include reasons like the existing firm controlling an essential resource, patents and copyrights, government regulations, etc.
In market structures with low or no BTE, (perfect competition or monopolistic competition, such firms in these industries make supernormal profits in the SR, new firms will be attracted by the supernormal profits to enter the industry and therefore, competes away the supernormal profits. In the LR, firms in these industries earn only normal profits.
Small firms under PC or MPC will have a small scope of EOS and therefore, they will end up with normal profits in the LR. However, the inability of new firms to enter due to barriers under monopoly or oligopoly would allow the existing firms to continue with the supernormal profits in the LR. For eg, firms have different cost conditions, a monopoly enjoys substantial economies of scale in production which leads to a vast reduction in AC when the firm increases production. The low costs would allow the monopolist to make supernormal profits in the LR.
(Differences in costs = natural BTE)
Differences in degree of competition
Under MPC, cos of the many firms existing in the market, there is a high degree of competition. As a result, profits are kept down b/c firms are unable to charge high prices without losing their customers to other sellers in the market. This is b/c the product differentiation is slight and therefore, firms will lose customers who will move to buy cheaper substitutes in the market. Under monopoly, with no competitor in the market, the monopolist has a greater leeway with price and therefore, his profits will not be competed away.
(Lack of competition mainly due to presence of legal BTE)
Size of the firm
Different market means different size of the firm relative to market. In PC or MPC, the firms are small and therefore, may not be able to adjust to changing market conditions. The firms may end up with losses when dd falls. There is lower ability to depend on past earning to the over hard times, Small firms also have less ability to expand when dd increases, therefore the size of the firm limits its ability to earn a high level of profit. However, a large firm will have the ability to deal with hard times as well as the ability to expand its business when times are good
Level 3 (7-10m): Thorough explanation of at least 2 aspects of market structure differences that contributed to the different profit levels
Level 2 (5-6m): Adequate explanation of how market structure differences contributed to the different profits
Level 1 (1-4m): Descriptive answer on why firms have different profit levels
JC Economics Essay – Firms’ Alternative Objectives
According to economic theory, a firm’s main objective is to maximize profits. To do so, the firm will produce the output to ensure that its TR > TC by the greatest margin. To achieve this, the firm will need to produce an output where MR=MRC. Therefore, the profit max motive will determine the output and pricing decision of the firm.
(Sketch diagram of price and output determination using MC=MR)
Under PC, to max profits, the firm will produce at min cost since it is a price taker. Under MPC, the firm will also try to minimize cost as that is one way to ensure competitiveness. In monopoly and oligopoly, firms have greater leeway in its price and output decisions since there are BTE which allow the firm to protect its profits. The level of profit made by the firm will determine its ability to innovate or not. Under PC and MPC, where the firm makes only normal profits in the LR, they have hardly any profits to engage in R + D to improve their products. This is b/c R+D activities incurs a high costs which may have no returns unless there is a successful outcome to the innovative process However, under monopoly or oligopoly, the ability to retain its supernormal profits would mean that the firm can engage in R + D since they have excess profits. The supernormal profits allow the firm to achieve dynamic efficiency. However, if the firm needs not worry about competition, it may not engage in R+D since there is no necessity to do so.
However, profit level does not always determine the behaviour of the firm. This said, the firm must still make at least normal profit (without external help) to remain in the industry in the LR. The other objectives include:
Market expansion objectives of sales or revenue max for large organizations, where the shareholders and the managers are separate groups of people, sales maximization and profit maximization and the interests of managers and shareholders may conflict, especially in the short run. To increase sales a firm may spend a large amount on advertising and/or cut prices, which may initially lower profits. Shareholders are likely to want a high proportion of profits distributed s dividends, whereas managers, concerned about growing the firm, will want to reinvest most of the profits in equipment and buildings. However, in the long run the two objectives may be compatible and both shareholders and managers may be happy if the actions taken in pursuit of sales maximization increase market share and raise long run profits.
Social objectives: Some firms may sacrifice some profits for care of the environment or workers’ welfare. Therefore, the motivation for their actions are not confined be just the profit level. Such objectives may appear to conflict with the profit motive in the short run but may, in fact, be compatible in the long run. For example, showing concern for the environment, say by not selling genetically modified food, is likely to raise a firm’s costs. However, it may also provide it with good publicity and may increase demand for its products. In the long run revenue may rise by more than costs and so profit may increase. Similarly, raising workers’ wages will increase costs in the short run but may reduce labour costs in the long run if the higher wages increase labour productivity and reduce labour turnover
EV: firms in real world have overlapping or multiple objectives. Eg is CSR (corporate and social responsibility). It also serves as a way to product differentiate, build product and company branding and image, serves as extra BTE!
EV: objectives maybe dynamic. Switching from profit max to maximising market share, as is the case of oligopolistic firms.
EV: difficult to profit max in reality. After all, MC concept is hard to estimate.
(More evaluation comments in our Accelerated JC Economics Revision courses)
Therefore, profit max may not always dictate how the firm will behave in the real world. But a min level of profit is necessary for the firm to survive in the real world. Any profit level higher than that, the firm is free to pursue other objectives that it chooses. It’s also noted that other objectives may not be in conflict with the profit-making objective of a firm.
L3 (7-10m): Thorough and balanced answer considering how profit level as well as other factors (at least 2 other factors) will determine firm’s behaviour in the real world
L2 (5-6m): Adequate answer considering how profit level as well as other factors will determine firm’s behaviour in the real world OR thorough explanation on one aspect of answer
L1 (1-4): Descriptive answer on how profits affect a firm’s behaviour
E2 (3-5m): Evaluative discussion supported by analysis
E1 (1-2m): Unexplained judgement
Link: Econs Essay #45 | #47