(2022) A Level H2 Econs Paper 2 Essay Q1

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1. Economists usually begin their analysis of decision-making by firms by assuming that the objective of a firm is to maximise its profit. In reality, however there are many different objectives that a firm might adopt.

a.Explain the likely effects on a firm’s price and output when its objectives changes from profit maximisation to profit satisficing. [10]

Explain & define the terms profit maximisation & profit satisficing

Profit maximisation is a typical assumed objective of a firm, where firms aim to maximise profits, usually by producing at an output level where Marginal Costs equal to Marginal Revenue.

Profit satisficing refers to an alternative scenario where managers in a firm may have different objectives compared to owners / shareholders of the firms. Managers, instead of maximising profits, may choose to operate at a level where instead of maximising profits, they produce at a level which may satisfy or placate shareholders / owner which may not necessarily be profit maximising. 

Profit maximising

When profit maximising, firms will choose to produce at a level where MC = MR

Why not MC > MR

At output level Q2, When MC is greater than MR, the firms incurs a loss with every additional unit produced - it is thus not a profit maximising level of output since the firm can increase profitability by reducing output level

Why not MC < MR

At output level Q1, When MR is greater than MC, the firm can make incremental increase in profits by producing an additional unit - the firm can thus increase profits by producing more units of output. This is thus also not a profit maximising level of output since the firm can increase profitability by increasing output level

MC = MR

It is thus only at the output level Q1 when MC = MR where profits are maximised.

How output and pricing may change when objective changes to profit maximisation

If managers are opting for profit satisficing as an objective - then the price can be set likely at anywhere in between the range at P1 (at output level Q1 where MC = MR) to P* (normal profits where AC = AR)

This depends on the degree of contestability as well as whether there is a threat of hit and run competition. 

A high degree of competition may see managers opting to move towards P* and produce at output level Q*

b. Discuss the most appropriate strategy that a firm could adopt if its objective was to reduce the competition that it faces. [15]

R&D to develop new/better products → increase barriers to entry

1. In the presence of existing supernormal profits, a firm could tap on retained supernormal profits to carry out research and development

2. R&D can help the firm to develop newer / better quality products

3. This can help the firm to distinguish itself from its competitors, develop products that are less substitutable and thus increase the barriers to entry & prevent competitors from entering the market to compete / reclaim market share from existing competitors

   
   Predatory pricing → subject to prior retained supernormal profits

1. If a firm has retained supernormal profits, it can adopt a strategy of predatory pricing

2. Predatory pricing is the practice of charging a price either below market price or to the extent of charging below cost price 

3. Predatory pricing is a game of attrition, firms carrying out predatory pricing may expect to make losses. If rival firms do not match in terms of pricing, the firm will gain market share as consumers switch over.

4. If rival firms match the pricing by lowering their own prices → they will likely make subnormal profits (losses) → eventually whichever firm is unable to sustain losses over a prolonged period of time will shut down and exist the industry

5. If the firm survives, the market is consolidated and customers from the rival firms which have now shut down may now switch over.

Merger → increase size of firms and devouring rival firms

1. Another common method firms may use to reduce competition is to purchase rival firms and undergo a merger

2. This will increase the size of the existing firm

3. Such increases in output size may allow the now larger merged firm to enjoy an increase in economies of scale → allowing the firm to charge lower prices → thereby compete away market share from other rival firms

Conclusion

There is no “most appropriate” single strategy as what might be considered to be appropriate depends on many factors including whether the firm as the financial resources to carry out merger and acquisitions, the number of firms and size of such firms of whom the firm considers to be competitors as well as whether there is available retained supernormal profits to withstand a prolonged period of predatory pricing (losses to be incurred)

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