In economic theory, a monopolist would determine the price and output that would maximise his profits. Discuss whether firms in the real world would always set prices at profit-maximising levels. [25]

This essay argues that, while according to economic theory, a rational monopolist would set MC = MR to maximise his profits, in the real world, firms sometimes do not want to maximise their profits because they sometimes have alternative aims like revenue maximisation, or are often unable to because of imperfect information and bounded rationality and depend on "rules of thumb" like cost-plus pricing.

On the one hand, a monopolist would rationally seek to maximise profits, using the MC = MR rule, or the profit maximisation rule (also known as the marginalist way or principle). A monopoly is defined as one dominant firm that produces a unique good with no close substitutes, for instance, De Beers in terms of diamonds or Microsoft in terms of the software that it produces. The market structure that a monopolist faces generally has very high barriers to entry, either in terms of natural barriers to entry like large economies of scale, or man-made barriers to entry like powerful legislation and patent rights, price setting power due to the large market share commanded by the monopolist, and often imperfect information exists in the market, just like it does in software and high capital-intensive technologies.

On the other hand, in the real world, firms often do not want to maximise profits. They may want to maximise their growth or revenue instead of profits. 

To maximise their growth and expansion, they could produce where AR = 0, which would maximise output, so as to extend their lead in the market and would thus promote the growth of their firm. 

To maximise revenue, firms could easily produce where MR = 0. This economic theory is particularly interesting. According to the famous economist William Baumol, if the aim of a firm is to maximise its sales instead of profits, one possibility is that it would produce where MR = 0. This is due to the issue of the division between ownership and control of a firm. With the separation of ownership and control in modern corporations, the issue is that managers of a firm, like the Chief Executive Officer or Managing Director, may seek prestige and higher salaries by trying to expand sales even if it were at the expense of profits, which would be shareholders’ interests. According to Baumol and Williamson, managers may seek to maximise their own utility rather than profit-maximise, which would benefit the firm. And according to Bearle and Means, the ownership of companies is spread out over a large number of shareholders with little individual power, while control and decision-making is in the hands of a few managers. 

However, some firms would aim to maximise their revenues but this would still be subject to "satisficing" – which means to reach at least a minimum level of profit, but a level which is lower than pure profit maximisation.

Another reason why firms may not maximise profits is that they are unable to do so, even if they are willing. According to Herbert Simon, decision makers face the situation of imperfect information and have to make decisions under uncertainty in the real world. Even though they may be rational or try to be, they eventually use what is known as “bounded rationality”, and therefore make decisions using the information that is available to them. Using Simon’s theory of bounded rationality necessitating satisficing, Cyert and March argued that real world firms aim for satisficing behaviour and even found empirical data to support their view. 

One alternative way of making pricing and output decisions is to use cost-plus pricing, which is basically to take P = AC + a mark up, which is why this method is called cost-plus pricing. Hall and Hitch would agree, as they argued that company executives often make decisions using “rules of thumb” rather than the marginalist way of MC = MR.

In conclusion, to a large extent firms in the real world do not aim at profit maximisation in the sense that they set MC = MR, and often are unwilling or unable to set MC = MR. They often operate under conditions of imperfect information and make bounded rational decisions, and may often use cost-plus pricing. However, to a large extent, firms that do not care at all about profits would not survive in the long run, and it is not a far stretch of the imagination to say that either by luck or by skill, in the long run, all firms would approximately reach a level of pricing and output that is profit maximising because firms that did not make profits would not have survived in the long run against their more rational and efficient competitors.

Economics Tutor's Comment - This is an excellent effort for the A levels that answers the economics question comprehensively. Also, the use of economic theory is very strong in this economics essay. Do think of which economics diagrams are needed to be drawn and explained in this essay to make it an even stronger paper that supports your case that you are making. Thank you for reading, and cheers.

JC Economics Essays - This useful and relevant economics essays site can help students studying economics do well at the A-Levels (Cambridge, A1/S, A2, H1/H2/H3 levels), and the international AS level economics examinations. IB students can also benefit from the top-quality economics content here. This economics website contributes useful economics content, lesson materials, examination tips and techniques, and model economics essays that students in both Singapore and the UK, as well as also all around the world, can use to excel in economics.

This excellent economics essay was jointly written and contributed by both SS and WT, the first, our editor of JC Economics Essays, and the second, our resident Economics expert who helps students understand the beauty of Economics and its applications in real life. (Some of the economics content for alternative theories of the firm was also learnt from economics modules/lessons at the University of Manchester - Business Economics in 2008.) Thank you for reading and cheers! 

Explain how, according to economic theory, a monopolist would determine the price and output that would maximise his profits. [8]

This essay explains how a rational monopolist would determine the price and output that would maximise his profits. A monopoly is defined as one dominant firm in a market that produces a unique good with no close substitutes, for instance, De Beers in terms of the diamond market or Microsoft in terms of software. The market structure that a monopolist faces generally has high barriers to entry, either in terms of natural or man-made barriers to entry, price setting power where the monopolist would set price and take the resulting output or set output and take the resulting price, and often imperfect information exists in the market. 

A profit maximising firm, not just a monopoly, would set its pricing and output decisions where MC = MR, the profit maximising rule or loss minimising rule. 

[What economics diagram would you draw here? And how would you explain this economics diagram? Economics tutor’s hint – draw a monopoly diagram and be careful to explain how this diagram answers the question posed.]

According to the diagram, the monopolist will set price and output at MC = MR, and the P > AC, thus earning the monopolist supernormal profits. The optimal price would be P* and the optimal output would be Q*, and the shaded area would be the supernormal profits generated from setting MC = MR. 

In conclusion, according to economic theory, rational firms which want to maximise their profits will set MC = MR and a monopolist is no exception. 

Economics Tutor's Comment - This is an excellent explanation for how the monopolist maximises his profits. It was based on an actual question set for the Economics at A levels. Also, the use of economic theory is strong in this economics essay, but the real question is: how could the theory be used even better with real world examples for each point to illustrate the context? Thank you for reading, and cheers. 

JC Economics Essays - This economics essays site is useful, accessible, and relevant for students studying economics, especially students taking the A-Levels (Cambridge, A1/S, A2, H1/H2 levels), and the international AS level economics examinations. And IB students can also benefit from the top-quality economics content in JC Economics Essays. This economics blog provides a range of useful economics content, materials, examination tips and techniques, and model essays that students in Singapore and the United Kingdom, as well as all around the world, can use to excel in their economics examinations. 

This top-quality model essay with sample comments was contributed by WT, our resident Economics expert who helps students understand the beauty of Economics and its applications in real life. WT has a strong interest in Econometrics, Economic History, International Trade, and Game Theory, especially applications to real life. This economics post was edited by S. S., the editor of JC Economics Essays. Thank you for reading. 

Discuss how far increased specialisation and low barriers to entry apply to the growth of online shopping. [15]

Internet or online shopping has grown rapidly in recent years. Low barriers to entry have allowed a wide range of small specialised retail firms to market their products on the Internet. At the same time economies of scale have led to a small number of large Internet retail companies dominating the market for other products.

Increased specialisation and low barriers to entry have an impact on consumers and existing producers.

Discuss how far the traditional analysis of these economic effects applies to the growth of online shopping. [15]

An economics student’s response to the H2 ‘A’ level Economics November 2012 Essay Question 3

Part (b) of the H2/ A level Economics N2012 Essay Question 3 is kindly contributed by WYWS

This paper argues that while increased specialisation and low barriers to entry are able to account for the growth of online shopping, there exist other equally important theories in which the online shopping industry could expand. These other ways include online shopping retailers growing internally by expanding over time, or by growing externally by integrating with other firms via mergers, acquisitions and takeovers. Besides growing, alternative theories of firms postulate that aside from maximising growth, real world firms may aim to maximise profits or revenue.

Increased specialisation refers to the division of labour, and thus economies of scale. In the long run, rational profit-maximising firms aim to produce at the minimum efficient scale (MES), the point where the long run average cost (LRAC) curve shops falling, or where economies of scale are first exhausted.

Draw relevant economics diagram here – what diagram should be drawn?

This aim allows the firms to minimise the possibility of being undercut by their competitors, while giving them the ability to undercut their competitors. By reaping economies of scale, firms are also able to obtain cost advantages unavailable to their competitors, which allows them to lower their cost of production, produce more output, and thus increase their profits. A form of division of labour could be dividing one software engineer’s job of maintaining the integrity of the website and formulating creative new ways to improve the website into a job for two people, such that each could focus more intensively on their job scopes, thereby resulting in a higher quality and quantity of output. By increasing specialisation, firms could therefore reap economies of scale and ultimately promote growth.

Besides increased specialisation, low barriers to entry could also lead to the growth of firms in the online shopping industry. Entrepreneurs are decisive risk takers, who seek to coordinate the factors of production of land, labour, and capital, to bring out an increase in output from a given input. Low barriers to entry – both artificial and natural – allow potential entrepreneurs to capitalise profitable opportunities by providing easy access into these profitable segments of the market. The entry of new competitors would therefore apply pressure on incumbent firms, lowering output prices, and improving the overall allocation of resources. Low barriers of entry and exit of the market would therefore ensure that firms which are efficient and producing in accordance to market demand would survive and prosper in the market, while firms which are inefficient and whose production are not geared to the market would face their demise.

Other than increased specialisation and low barriers to entry, firms in the online shopping industry could grow by expanding internally over time or externally by integrating with other firms. There exists three types of integration, namely horizontal, vertical and conglomerate integration. Horizontal integration occurs when two firms that are producing the same product, or are engaged in the same stage of production, combine to form one entity. Vertical integration occurs when a firm in a stage of production combines with another firm from another stage of production, and consists of forward and backward integration. Forward integration occurs when a firm integrates with another firm at the next stage of production. Backward integration occurs when a firm integrates with another firm at an earlier stage of production. E-commerce oligopoly Amazon for instance, would have undergone vertical integration, as it does not only provide the service enabling consumers to search for products online, but also handles the logistics of delivering the product to the consumer’s doorstep. Conglomerate integration occurs when a firm mergers or acquires another firm from an unrelated industry.

Aside from expanding internally or externally, there exists several alternative theories of the firm which theorise that firms maximise profit and revenue, besides maximising growth. Maximising sales revenue increases the firm’s market share, which increases the prestige of the firm’s managers. Maximising growth via maximising output incurs additional costs such as advertising, investment, and research and development, but this would pay off in the long run with an expansion of demand and capacity. The behavioural theory of the firm by Cyert and March uses Herbert Simon’s theory of bounded rationality necessitating satisficing to argue that real world firms aim for satisficing behaviour, and proved this with real world empirical data. Satisficing refers to managers aiming to achieve other objectives by maintaining a satisfactory level of output to keep shareholders happy, rather than maximising growth. The managerial theory of the firm by Baumol and Williamson argues that managers seek to maximise their own utility rather than maximising growth. Bearle and Means argued regarding the ownership and control of the firms, where ownership of the firm is often spread over a large number of shareholders, and conversely control of the firm is often in the hands of a few managers.

Draw relevant economics diagram here – what diagram should be drawn?

According to the diagram above depicting a monopoly, firms can choose to maximise profit, revenue, or output, all of which would result in different levels of P and Q to be chosen, depending on the aims and objectives of the mangers. To maximise profit, managers aim to produce at marginal cost (MC) = marginal revenue (MR), at price P1 and output Q1. To maximise revenue, managers aim to produce where MR=0, at price P2 and output Q2 and still earn supernormal profits. To maximise growth, mangers aim to produce at average cost (AC) = average revenue (AR) and earn normal profits. Hence, applying this to oligopolies and monopolistic competitive firms in the online shopping industries, these firms could choose to maximise profits or revenue instead of maximising growth.

In conclusion, traditional analysis of increased specialisation and low barriers to entry are not as effective as alternative theories of the firm in analysing the growth of online shopping. The reason being is that the online shopping is a relatively new concept, since many consumers only have access to fast, reliable Internet post 20^th century. Therefore, imperfect information largely exists in such industries as compared to real world industries such as agriculture, thereby rendering traditional economic theories on the growth of the former being less accurate and reliable to alternative theories of the firm. However, these traditional analysis are still useful in certain cases, and therefore it is vital to keep them in our economic analysis toolkit.

JC Economics Essays – Special thanks to WY for his excellent contribution of a well-argued, well-written, and clearly-worded economics essay on the H2 / A level economics November 2012 examination essay question on market structure, economies of scale, barriers to entry, alternative theories of the firm, and internet retail firms.

Covering a lot of good economics material, this exemplary economics essay is an excellent model essay on how to effectively tackle examination questions. It succeeds greatly by using various economic theories and examples, and relevant economics diagrams, all targeted at making a reasoned, reasonable, and rational response to the economics essay question. This economics paper would easily achieve a grade A from an economics tutor during an examination. What else can you learn from this essay? 

Thank you for reading and cheers! 

Explain the possible alternative aims of firms. [25]

According to economic theory, firms are supposed to be profit maximising entities, where MC = MR. However, in real life, this does not seem to be always the case. Explain the possible alternative aims of firms. [25]

According to economic theory, firms are supposed to be profit-maximising entities, producing output where their marginal cost of production equals to marginal revenue (MC = MR). However, in real life, this does not seem to be always the case. This paper explains some of the possible alternative aims of firms: profit satisficing, sales maximisation, and growth maximisation. This is due to the central idea that firms may want to maximise profits, but either they do not know how to due to imperfect information, or they do not want to due to alternative goals and aims. This paper does not discuss those areas of analysis but instead focuses on a few alternative possible aims.

Alternative Aims of Firms: Profit Satisficing

One alternative aim of firms is profit satisficing. In many firms, there is separation of ownership and control. Those who own the company (the shareholders) often do not get involved in the day-to-day running of the company. This is a problem because although the owners may want to maximise profits, the managers, who run the company, have much less incentive to maximise profits because they do not get the same rewards as the shareholders do. Therefore, managers may create a minimum level of profit to keep the shareholders happy, but then maximise other objectives relevant to them such as enjoying work, maximising prestige, and other private goals. This is the problem of separation between ownership and manager and can possibly be overcome, to some extent, by giving mangers share options and performance-related pay to align their incentives, although in some industries it is difficult to measure performance.

Alternative Aims of Firms: Sales Maximisation

Sales maximisation is another possible goal and occurs when the firm sells as much as possible without making a loss, rather than maximising profits. Firms often seek to increase their market share by increasing their sales even if it means less profit. This could occur for various reasons. First, increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run. Secondly, managers prefer to work for bigger companies as it leads to greater prestige and higher salaries. Thirdly, increasing market share may force rivals out of business; for example, supermarkets have lead to the demise of many local shops. Some firms may actually engage in “predatory pricing” which involves making a loss to force a rival out of business. As long as their costs are covered, firms may reduce their prices to drive their rivals out of the market.

Alternative Aims of Firms: Growth Maximisation

Another possible aim of a firm other than profit maximisation might be growth maximisation. This is the idea of expansion and growth, and is similar to sales maximisation and may involve mergers and takeovers. A merger is a union of two companies, and can be hostile or friendly. A takeover is an acquisition of another company by a firm. First, similar to sales maximisation, increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run. Secondly, managers prefer to work for bigger companies as it leads to greater prestige and higher salaries. Thirdly, increasing market share may force rivals out of business; for example, supermarkets have lead to the demise of many local shops. Some firms may actually engage in “predatory pricing” which involves making a loss to force a rival out of business. As long as their costs are covered, firms may reduce their prices to drive their rivals out of the market.

Conclusions

In conclusion, while firms are supposed to be profit-maximising entities according to theory, producing where their marginal cost of production equals to marginal revenue, in real life, this does not seem to be always the case. This paper explained profit satisficing, sales maximisation, and growth maximisation as possible alternative aims of firms in the real world. However, in the long run, profit maximisation of theory should be the long term aim of firms, because if they do not maximise profits in the long run, they will find themselves outcompeted by firms that have followed a more rational pattern of behaviour, and in the competitive marketplace, “only the fittest survive”.

JC Economics Essays – Tutor's Commentary: Right off the bat, there are a few things missing from this particular "alternative aims of the firm" essay, which you should know and write about: the diagram of the Baumol model could be included. Furthermore, the standard Economics perfect competition diagram could also be added too. Let’s do an intellectual exercise here: think about how your Economics tutors in school would judge this Economics essay. What were its strengths and weaknesses, and why do you think those parts of the essay were strengths or weaknesses? If you were this student’s Econs tutor, how would you suggest advice so that you could make the student improve on his or her writing skills, and answering techniques? Be sure to ask critical and thinking questions; and always draw an Economics diagram (or two diagrams or more, if the need arises)! Thanks for reading and cheers.