Introductory Task

Profit Maximisation

We typically assume that firms aim to maximise profits, although there are examples when this is not the case. As well as considering these, we will consider alternative price strategies followed by firms, including price discrimination, where firms may charge different prices to different groups of customers. We also consider the concept of contestable markets.

Growth of Firms

Many firms naturally grow over time, due to some of the disadvantages to a firm of staying small, such as difficulties in obtaining finance, and competitive disadvantages with larger firms. Another incentive to grow is to obtain greater market power, possibly even exercising some influence over product price.

• We distinguish between the following ways that a firm can grow:
  • organic growth, which can come from increasing market share, or diversifying production activities to enter new markets with an existing product, or to offer new products. A goods example is Virgin, which started as a mail order record company, but eventually diversified to offer a wide range of products, including aeroplane flights and banking services. There are, of course, dangers in diversification, as it can be challenging to enter a market without the level of experience that rival firms enjoy.
  • mergers and acquisitions – a merger is typically consensual, whereas an acquisition may be hostile. These can lead to greater efficiencies, by streamlining management teams and removing repeated functions (e.g. payroll departments). However firms often have certain cultures, and mergers can be unsuccessful because of a clash between different corporate cultures. We can think of mergers as fitting into three categories:
    1. A horizontal merger is a merger between firms operating in the same industry, this would be the case, for instance, if KFC and Burger King merged into a single firm. Such a merger can affect the degree of market concentration and increase the market power of the new firm.
    2. A vertical merger happens if a company mergers with one of their suppliers, for instance if British Airways were to merge with Boeing, known as backward integration, or if food producer Northern Foods were to merge with the supermarket Tesco, known as forward integration. Vertical integration allows rationalisation of the process of production. Car producers, for instance, often use Just in Time production and so are dependent on the rapid availability of parts, which is much easier to achieve if the parts producer is part of the same firm.
    3. A conglomerate merger is a merger between two firms operating in quite different markets, for instance if KFC merged with Volkswagen. Such a merger can reduce the risk faced by firms, by spreading their market activity over a range of markets. However they may be inefficient, by management failing to specialise in a specific market, and investors often prefer firms to specialise so the investor can tailor their investment to achieve the diversity they require, whilst firms specialise in their areas of expertise.

Exercise

Different Motivations of Firms

With larger firms, particularly public limited companies, the owners are often not involved in running the business, which can lead to a problem of agency (the principal-agent problem) where the interests of those who run the business may diverge from the interests of the owners. Here there is also considerable asymmetry of information, with the owners knowing less about the details of the business than those who run it.

One situation, highlighted by Herbert Simon, is satisficing, where managers try to make their life easy by producing “just enough”, rather than maximising profits. Also, lack of accountability may make managers become negligent and not minimise costs, known as X-inefficiency. Managers may also pursue other objectives, such as retaining a large work force or ensuring that company money is used for employee perks, such as swanky offices and prestigious company cars.

William Baumol pointed out that managers will often seek to maximise revenue rather than profit, as their salaries are often more directly tied to revenue. This can lead to overproduction and a lower price than the equilibrium price.

Comparing perfect competition and monopoly

We can simplify our comparison of perfect competition with monopoly by ignoring any economies of scale (this artificial assumption can at a later stage be relaxed). Let’s consider the diagram below:

Here we see the demand (D=AR) curve and supply curve (LRS) under perfect competition, which produce a price of P_pc and a combined output by the firms in the market of Q_pc. In this situation consumer surplus is the area of the triangle AP_pcE.

By contrast, in a monopoly, the LRS curve can be considered as the long-run marginal cost curve. The monopoly company faces the marginal revenue (MS) curve directly and so will maximise profits at price P_m, with quantity Q_m produced. So they are producing less output and charging a higher price. The blue shaded area shows the additional benefit the monopoly firm has take from the consumer surplus and the red shaded area shows the deadweight loss that is a lost benefit felt neither by the consumer nor by the monopoly firm. It is worth noting however that the loss in allocative efficiency shown above may be partly offset by improved productive efficiency because a monopoly can utilise economies of scale that would not be available if a large number of small firms were instead competing.

Exercise

Pricing Strategies

In a situation of Perfect (or First Degree) Price Discrimination, a monopolist is able to charge each consumer a price equal to their willingness to pay for the good. In this situation the demand curve effectively becomes the marginal revenue curve, as it represents the amount that the monopolist receives for each unit of the good. In this situation there is no deadweight and the monopolist receives the entire consumer surplus amount as its producer surplus. The closest situation to this in the real world could be a commissioned work of art, where the price is a matter of negotiation between the buyer and the seller. Partial Price Discrimination occurs when students or older people get discounted access to the theatre or to public transport.

Price discrimination requires three conditions to be met:

• The firm has market power;
• The firm has information about consumers and their willingness to pay; and
• Consumers have limited ability to resell the product (which would lead to arbitrage, whereby those who are able to buy the product cheap resell it at an intermediate price to those that aren’t, taking away the firm’s ability to sell at a higher price and to price discriminate).

Economists distinguish three types of price discrimination:

First Degree Price Discrimination – Monopolist is able to charge each individual consumer the maximum amount they are prepared to pay for a product. e.g sales on e-bay where customers bid for a product.

Second Degree Price Discrimination – Different prices are charged for different (successive) blocks of consumption. e.g. sales of utilities, such as electricity, where after a certain quantity of sales in a fixed period the prices are reduced.

Third Degree Price Discriminations – Selling the same product in different markets to different consumers at different prices. e.g. different fares on public transport for different aged people, or difference between price for a product in domestic and foreign markets.

Task 1 – Price Discrimination

Task 2 – Price Discrimination

Task – Debate

This house believes that price discrimination is in the public interest.

Other influences on pricing

Below we consider some alternative possibilities at which firms may set a price:

To maximise profits, a firm will choose outputs such that marginal revenue is equal to marginal costs (i.e. Q₁) and set the price at P₁. To maximise revenue they will choose output at the point where marginal revenue is at zero, i.e. Q₂, leading to the lower price of P₂. To maximise sales they will increase output to the point where the price equals the average cost, i.e. Q₄, leading to the lowest price of P₄. Notice on the diagram that the additional point (Q₃,P₃) has been marked on where price is equal to marginal cost. This is the point of greatest allocative efficiency, but there is no obvious reason why a firm would choose this.

Exercise

Predatory pricing is an anti-competitive strategy in which a firm sets price below average variable cost to force rivals out of the market and achieve market dominance. It is illegal in the UK, as other than driving rivals out of a market there is no other justification for a firm setting their price below their average variable costs (known as the Areeda-Turner Principle). It may seem that this would benefit the consumer, due to the lower prices, but in the long-term the surviving firm will seek to recoup the losses by increasing the price and so the consumer will eventually suffer due to the lack of competition.

A less extreme pricing strategy is limit pricing. This effectively involves a firm not taking advantage of supernormal profits, but instead maintaining a lower price to prevent new entrants being incentivised to join the market, instead the firm increases its market share.

As well as barriers to entry, a firm may also have barriers to exit, as in leaving a market they will have to abandon any sunk costs that were invested in order to enter the market (e.g. purchase of expensive capital equipment and use of advertising and market research).

William Baumol, in the 1980s, developed the theory of contestable markets which suggests that in some markets in order to prevent new entrants entering the market, the existing firm needs to keep prices so low that they are unable to achieve supernormal profits (i.e. the threat of new entrants has the same impact that actual new entrants would). This is the case in markets with no barriers to entry or exit, no sunk costs and no special (e.g. technological) advantage enjoyed by the current firm. In this situation, not keeping costs at this low price can lead to “hit and run” new entrants entering the market, exploiting the supernormal profits, and then leaving again when the profits have returned to the normal level.

Task – Contestable Markets

Closing Task