Firms’ objectives and behaviourAndy

Firms’ objectives and behaviour
Andy Rees
Introduction
To fully appreciate the game of football we need a clear understanding of the rules and aim of the game. Once we realise that the basic objective is for each team to place the ball in its opponent’s goal we can start to appraise each team’s performance.

We may also propose improvements to a team’s tactics to enhance its chance of achieving its objective. This sporting analogy has clear relevance to our study of the firm. To understand and appraise a firm’s performance we must first find out what the firm is seeking to achieve. We previously assumed that the sole aim of the firm is to maximise profit. Using this assumption we can then predict the price and output policy of firms under different market structures from perfect competition to monopoly (see Chapter 7). Is it reasonable to assume, however, that the firm will always seek to maximise profit? Perhaps the firm wishes to maximise something other than profit, or perhaps it has a range of goals and might feel it inappropriate to maximise any single goal at the expense of another.

Within this chapter we will question the applicability of profit maximisation and suggest alternative objectives for the firm.

The problems with profit maximization
There are two basic questions:
1 Does the firm have sufficient knowledge to maximise profit?
2 Would a firm wish to maximise profit?
We will look at each question in turn.

6.2.1 Does the firm have sufficient knowledge to maximise profit?

In Chapter 5 we set out the conditions whereby a firm could maximise profit. This required the firm to identify the level of output where the revenue gained from selling the last unit (marginal revenue) was equal to the cost of producing that unit (marginal cost), and setting price accordingly. Identifying this level of output therefore implies a knowledge of the value of marginal revenue (MR) and marginal cost (MC) at all levels of output. This is clearly a difficult task.

To identify MR, the firm requires knowledge of the demand for its product at all prices, i.e. it should be able to identify its demand curve. However, as noted in Chapter 3, the large number of explanatory variables determining demand makes this difficult. Although the firm might be aware of its sales at the current price, it would be less sure of sales at alternative prices, and sales at previous prices might be a poor guide to future sales given that ‘other conditions of demand’ would be likely to have changed. For example, the prices charged by rival firms might now differ. In short, the firm is likely to possess less than perfect knowledge. There might, however, be a danger of exaggerating the problem in that the firm would only realistically be interested in the level of demand over a certain price range. Statistical and survey techniques also exist that allow the firm to estimate its demand curve. The firm may also gain knowledge through market experience. Nevertheless, the problem remains.

There are similar problems in identifying the value of marginal cost (MC) at different levels of output. Imagine a firm producing ball bearings. It is unrealistic to expect it to be able to estimate the additional cost of producing a single additional ‘ball’ when it might be producing many thousands in a given production shift. Many, if not most, firms would have a similar problem. However, firms are often better placed to estimate the cost of an extra batch or run of production. As we will see in Chapter 9, this is the approach used in incremental pricing, where instead of pricing on the basis of single unit changes of output, and the corresponding values of MC and MR, the firm instead looks at discrete (incremental) changes in output.