IB Economics Ch 7: Theories of the Firm

Profit Maximisation

and Possible Alternatives

Profit Maximisation

• Economists usually assume that the main aim of a firm is to maximise profits.

• If the marginal revenue of producing another unit of output is greater than the marginal cost the firm could increase profit by producing more.

• If the firm finds that MR>MC, it should increase production.

• Profit is maximised by producing at the point where the MC curve cuts the MR curve from below (MC=MR).

Profit Maximisation

Output (units)

Pri

ce (

$)

D=AR=MR

MC

Profit Maximisation

Quantity (units)

Pri

ce (

$)

D=ARMR

Alternative Theories of the Firm

• In reality, firms may not always have the main aim of maximising profits.

• Not everyone has studied economics and understands the concepts.

• Problems measuring the profit-maximising level of output.

• If the profit-maximising level of output is 12,000 units - it may be hard for the firm to stop production at exactly this amount.

Revunue Maximisation

• Entrepreneurs often measure success by the amount of revenue that they make.

• In this case they may attempt to maximise their sales revenue by producing where MR=0.

• They will produce above the profit-maximising level of output.

Revenue Maximisation

Quantity (units)

Pri

ce (

$)

MR D=AR

Sales Maximisation

• Entrepreneurs often believe that the more they sell, the better they will do.

• In reality, they may be able to generate greater profits by charging a higher price and selling less.

• This is often the case when salesmen work on a commission basis.

• Commission gives them the incentive to maximise sales rather than profit.

Sales Maximisation

• Firms may also wish to maximise sales in the short run in an attempt increase sales or to grab market share from their competitors.

• Sales-maximising firms who wish to earn normal profits will operate where AC=AR.

• Firms may resort to predatory pricing to increase market share.

Sales Maximisation

Quantity (units)

Pri

ce (

$)

MR D=AR

Maximising Employment

• Entrepreneurs sometimes measure their success by the number of workers they employ.

• Having a larger workforce does not necessarily mean that profits will be greater.

Environmental and Social Aims

• Entrepreneurs who are interested in environmental and social issues may be prepared to pay higher prices for raw materials from a source that is environmentally friendly or does not involve the exploitation of labour.

• Examples: The Body Shop, Fairtrade, Oxfam.

Satisficing

• Some economic theories doubt whether entrepreneurs ever attempt to maximise profits.

• They suggest that entrepreneurs “satisfice”.• If people own firms they will work hard enough to

make a reasonable living but will not push themselves further.

• If managers run the firm they will make enough profit to keep the owners of the firm happy. If they keep their jobs there is no incentive push further to maximise profits.

Exam Question

Mark Scheme