Major Pricing Objectives of a Firm

Pricing objectives are usually considered a part of the general strategy for achieving a broadly defined goal. The firm may aim at one or more of the following objectives. There are other objectives of the firm, which can be analyzed as follows:

1. Profit maximization: According to economic theory, every business unit is guided by profit maximization. Thus, the objective of profit maximization has become the main pricing objectives of a firm. Similarly, profit has also become the measure of the success of the entrepreneur and maximization of profits for the entire product line. Firms set a price, which would enhance the sale of the entire product line rather than yield a profit on one product only.
2. Target return on investment (ROI): Return on investment (ROI) may be the long-term objective of the firm. Under this, profits and costs objectives are depended on standard volume and the margins added to standard costs and designed to produce the target profit rate in investment.
3. Stabilize price: Stabilization of price may be the one of the pricing objectives. Stable price helps to forecast production, sales, use of inputs, investment etc. The stable price also attracts consumer’s interest and preferences for the product of the firm which increases profit of the firm.
4. Determine price according to competitive condition: Adaptation of prices to bit the diverse competitive situations faced by different products. Market competition relatively low price may be set to stimulate market growth and capture a large share thereof.
5. Welfare of the firm in the long-term: Every business firm aims long term welfare of the firm. Promotion of the long-range welfare of the firm, i.e. discouraging the entry of competitors.
6. Flexibility: Flexibility to vary prices to meet changes in economic conditions affecting the various consumer industries.

There must be set the price of product according to consumer’s purchasing power and government policy.

 Some Related Links:      

• Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints

• Profit Maximization Objective of a Firm

• Reasons behind aiming at reasonable profit rather than maximum profit by most of firms

• Williamson’s Model of Managerial Discretion

• Scope of Managerial Economics

• Pricing: Meaning, Objectives and Importance of Pricing

• Marginal efficiency of capital and rate of interest influence the investment decisions | Evaluation of Investment Project by Benefit-Cost Ratio Method

Reasons behind aiming at reasonable profit rather than maximum profit by most of firms

In economic theories, it is assumed that maximizing profits is the basic objective of every firm. The volume of profit is regarded as the primary measure of the success of a business. But in recent days, it has been realized that many firms, particularly big one do not operate on the principle of profit maximization in terms of marginal costs and revenues. Instead, the firms set standards or targets of reasonable profits.

This is because of so many reasons. The firms may limit profit or aim at only reasonable profits due to following reasons:

1. Discourage potential competitors: When a firm earns large profit under profit maximizing objective. It is likely to attract potential competitors to enter the field and capture the market share enjoyed by it. They adopt the practices such as infringement of patent rights, copying of product designs, encroachment upon the firm’s sources of raw materials, etc. To discourage such tendency, a firm may adopt the policy of limiting profits rather than maximization. The danger of potential competition is more serious when the firm enjoys a weak monopoly situation. However, there is no guarantee that limiting profits may prevent potential competition.
2. Project a favorable image to the public and government: The earning of high profits shows the enjoying of monopoly power. It may create an impression that the firm is exploiting the consumers. Hence, the public may appeal the government for nationalization of the firm or to exercise some sort of regulation of prices, profits and dividends. Therefore, the firms may aim at only reasonable profit. Restraining demand for wage hike. When there is high profit the labors may demand higher wages. This is particularly true in the industries having strong trade unions. Hence, such industries may not like to maximize profits. Because, this may lead to wage price spiral.
3. Maintaining consumer goodwill: The consumer goodwill is of great importance to the industries. The consumers show their resentment and think that they are being exploited when prices are set too high. The consumers expect a fair price in terms of cost of production. Similarly, if a firm exploits a short-term situation, it may seriously damage its image, reputation and long-run interests. Hence, the profit restraint is adopted to maintain consumer goodwill.
4. Keeping internal control: Another reason for restraining profits is management’s desire to maintain control of the firm. The management gives strong preference to liquidity, abhors debt and may not like expansion. Because maximizing profits may require entering new areas of production involving heavy investments and thus, reducing liquidity and losing control.
5. Maintaining congenial working conditions: Profit restraint is also adopted to maintain congenial working conditions within a firm. There is growing awareness about the social responsibilities of management. There is increasing concern with the direct effects of management’s decision upon workers, consumers and the business cycle.
6. Attainment of industry leadership: If a firm aims at achieving industry leadership, the firm may try for maximum sales or manufacturer of maximum product lines. Hence, profit maximization will not get the priority. The entrepreneur may merely seek to earn a satisfactory profit level so as to maintain certain share of market or a certain level of sales.
7. Avoiding risk: Profit maximization may require setting up new ventures, which may have number of uncertainties. The project appeared profitable at the outset may turn out to be unprofitable.

It is now clear that all firms may not aim at profit maximization. But they try to achieve satisfactory level of profit to cover the risks of economic activity and to avoid loss. A business cannot survive if there is continuous loss. Profits are indispensable to remain alive. Profits are essentially means to an end, and the end of continuity and growth of the firm.

  SOME RELATED LINKS:  

• Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints

• Profit Maximization Objective of a Firm

• Major Pricing Objectives of a Firm

• H. A. Simon opines that firms aim at satisfying rather than maximizing

• Scope of Managerial Economics

Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints | Boumol's Theory of Sales Maximization

Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints.

Boumol’s theory of sales maximization is an alternative theory of firm’s behavior. The basic premise of this theory is that sales maximization, rather than profit maximization, is the plausible goal of the firm. As pointed by him, there is no reason to believe that all firms seek to maximize their profits.

Business firms pursue a number of incompatible objectives and it is not easy to single out one as the most common objective pursued by the firms. His observation shows that more managers seek to maximize sales revenue rather than profits. He argues that in modern business management is separated from ownership, and managers enjoy the discretion to pursue goals other than profit maximization. According to Boumol, business managers pursue the goal of sales maximization for the following reasons:

1. Financial institutions consider sales as an index of performance of the firm and willing to finance to the firm with growing sales.
2. Profit figures are available only annually, sales figures can be obtained easily and more frequently to assess the performance of the management. Maximization of sales is more satisfying for the managers than the maximization of profits which go to the pockets of the shareholders.
3. Salaries and slack earnings of the top managers linked more closely to sales than to profit.
4. The routine personal problems are more easily handled with growing sales. Higher payments may be offered to employees. Sales figure indicate better performance. Profits are generally known after a year.
5. If profit maximization is the goal and it rises in one period to an unusually high level, this becomes the standard profit target for the shareholders which managers find very difficult to maintain in the long-run.
6. Sales growing more than proportionately to market expansion indicate growing market share and a greater competitive strength and bargaining power of a firm in a collective oligopoly.

Under sales maximizing objective, output is greater and price is lower under the objective of profit maximization. Hence, Boumol has described two types of equilibrium under sales maximization objective which are;

1. Without profit constraint to sales maximization, & 
2. There is profit constraint to sales maximization

In the figure, total profit curve (TP) measures the vertical distance between the total revenue and that cost at various levels of output. At first, total profit rises and after a profit falls downwards.

If the firm is a profit maximizer, it would produce the level of output OA. However, in Boumol’s model, the firm is sales maximizer, but it must also earn a minimum level of profit. The acceptable level of profit is OM. The firm will produce the level of output OB which maximizes its sales revenue. The firm earns profit BE, which is less than the maximum attainable profit AH. At this point, output OB total revenue is BR1. The figure shows that sales or total revenue maximizing output OB is larger than profit maximizing output OA.

The firm aims at sales maximization subject to a profit constraint as Boumol contended. If OM is the minimum total profit, which firm wants, then ML is the minimum profit line. This minimum profit line ML cuts TP curve at point E. There, the firm produces and sells OB output.

At output OB, the firm will have total revenue equal to BR1, which has less maximum possible total revenue of CR2. It should be noted that the firm can earn minimum profit ON even by producing ON output. But total revenue at output OH is much less than at output OB. In summary, two types of equilibrium appear to be possible. One in which the constraint provides no effective barrier to sales maximization. The firm is assumed to be able to pursue an independent price policy that is to set its price so as to achieve its goal of sales maximization (given the profit constraint) without being concerned about the reactions of competitors.

A profit maximizer produces the output OB defined by the equilibrium

 

Given that the marginal cost is always positive, it is obvious that at the level OB, the marginal revenue is also positive. That is TR is still increasing at OB, since its slope is still positive. In other words, the maximum of TR curve occurs to the right of the level of output at which profit is maximized.

The sales maximize sells at a price lower than profit maximize. The price at any level of output is the slope of the line through the origin to the relevant point of the total revenue curve (corresponding to the particular level of output).

Criticisms of Boumol's Theory of Sales Maximization

This model is not also free from certain weaknesses as below:

1. As pointed by Boumol, sales maximize will in general produce and advertise more than a profit maximize, which is invalid. Hawkins comments that a sales-maximizer may choose a higher, lower or identical output and a higher, lower or advertising budget. It depends on the responsiveness of demand to advertising rather than price cuts.
2. In case of multi-products, Baumol has argued that revenue and profit maximization yield the same results. But Williamson has shown that sales maximization yields different results from profit maximization.
3. This model fails to explain observed market situations in which price are kept for considerable time periods in the range of inelastic demand.
4. This model ignores the interdependence of the price of oligopolistic firms.
5. It ignores not only actual competition, but also the threat of potential competition from rival oligopolistic firms.
6. This model does not show how equilibrium in an industry in which all firms are sales maximizers, will be attained. Baumol does not establish the relationship between the firms and industry.

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• Concept of Oligopoly and Kinked Demand Curve Model

• Meaning of The Game Theory and Importance of Game Theory

• Profit Maximization Objective of a Firm

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• Reasons behind aiming at reasonable profit rather than maximum profit by most of firms

• The Cyert and March Theory of Firm | Firm depends on the demand of the members of the coalition

Profit Maximization Objective of a Firm | Total Revenue (TR) - Total Cost (TC) Approach | Marginal Revenue (MR) - Marginal Cost (MC) Approach

Profit maximization is the most accurate description of managerial goal. The profit maximization is one of the very important assumptions of economic theory, which always assumes that a firm aims to maximize profit. The attempt of an entrepreneur to maximize profit is regarded as a rational behavior. Hence, profit maximization continues to be a central concept in managerial economics.

There are two approaches to explain the equilibrium of a firm on the context of profit maximization. Among them one is old method of total cost and total revenue approach and another is the marginal revenue and marginal cost approach.

Total Revenue (TR) – Total Cost (TC) Approach

Total revenue (TR) and total cost (TC) approach is the simplest method to determine the equilibrium of a firm. To calculate the profit of a firm, we find out the difference between the total revenue and total cost at difference levels of output. A firm is said to be in equilibrium when the difference between total revenue (TR) and total cost (TC) is maximum. Every rational producer will try to maximize his profit. We can find equilibrium of a firm with the help of this approach both under perfect and imperfect (monopoly) market competition.

i) Equilibrium of the firm under perfect competition

The firm is in equilibrium when it has no incentive to change its level of output. In perfect competition, a firm is said to be in equilibrium when it maximizes its profits (π), which is defined as the difference between total revenue and total cost.

 

π = TR – TC

Where,

π = profit,

TR = Total Revenue and

TC = Total Cost

Given that the normal profit rate is included in the cost items of the firm, π is the profit above the normal rate of return on capital and the remuneration for the risk bearing function of the entrepreneur. The firm is in equilibrium when it produces the output that maximized the differences between total receipts (Revenue) and total costs. The equilibrium of the firm can be explained with the help of the following figure:

As shown in the figure, TR and TC are total revenue and total cost curves of a firm in a perfectly competitive market. TR curve in a straight line through the origin, showing that the price is constant at all levels of output. The firm is a price taker and can sell any amount of output at the going market price, with its TR increasing proportionately with its sales. The slope of TR curve is the MR. It is constant and equal to the prevailing market price. Since all units are sold at the same price.

The slope of TC curves reflects ‘U’ shape of the AC curve i.e. law of variable proportions. The firm maximizes its profit at the output ‘OX’, where the distance between TR and TC is the greatest. At the lower (OX1) and higher levels (OX2) than OX, the firm has losses. The TR-TC approach awkward to use when firms are combined together in the study of the industry.

ii) Equilibrium of the Firm under Imperfect Competition (Monopoly)

Under imperfect competition, AR and MR of a firm are two different things. This is because under imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost and the marginal cost curve should cut the marginal revenue curve from below.

 

It is shown in the figure, at the beginning, total cost is higher than total revenue. There is no profit. At points P and Q, total revenue is equal to total cost. So, there is neither profit nor loss and is called the break-even point. After OA output, total revenue is higher than total cost, so profit begins to show. At OB output, the difference between total revenue and total cost is maximum. The firm is in equilibrium and earns maximum profit, TR - TC (EB - NB) = EN is profit. Point Q is again the break-even point. Beyond OC output, total cost exceeds total revenue and the firm incurs losses. In case of perfect competition, the TR become the straight line.

 

Marginal Revenue (MR) - Marginal Cost (MC) Approach

Marginal revenue and marginal cost approach is another method to know the equilibrium of a firm. The modern economist Mrs. John Robinson propounded this approach. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue (MR) should be equal to marginal cost (MC) and the marginal cost curve should - cut the marginal revenue curve from below. It will be profitable for a firm to increase its production when MR exceeds MC.

i) Equilibrium of the firm under perfect competition

The equilibrium of a firm in the perfect competition can also be shown through the help of marginal revenue (MR) and marginal cost (MC) approach. For fulfilling the condition of maximum profit, marginal cost (MC) must be less than marginal revenue (MR). A firm is said to be in equilibrium when marginal cost (MC) must be equal to the marginal revenue (MR) or MC curve must intersect MR curve from below. It is shown in the figure:

In the figure, AR and MR are the same and AR = MR is a straight line. It is assumed that MC falls at first and then starts rising. MC curve cuts MR curve at E point from below and it is equal to MR. The profit maximizing output is OQ where firm fulfills two basic conditions of equilibrium.

ii) Equilibrium of a firm under imperfect competition (Monopoly)

Under imperfect competition, AR and MR of a firm are two different things. This is because under imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost and marginal cost curve should cut the marginal revenue curve from below.

 

In this figure, at point E both the conditions of equilibrium have been fulfilled. Hence, E is the point of equilibrium. The firm gets equilibrium at OM output where marginal revenue is equal to marginal cost. The OM quality of output is sold at price OP price. Before OM output, the increase in output add more to revenue than to cost but after OM output, the increase in output adds more to cost than revenue. Profit is the total revenue OMQP minus total cost OMNR. Hence, the firm earns the abnormal profit equal to RNQP.

Criticisms/ Demerits of Profit Maximization Theory

The objective has been criticized by some economists saying there may have other objectives in a firm such as sales maximization, welfare or satisfactions etc. This objective is criticized on the following grounds.

1. Profit maximization criterion is vague and ambiguous. Profit may be long-term, after tax or before tax. It is not clear.
2. In this objective, total profit earned during the life of assets and timing of their realization is ignored. Hence, equal value for earning realized on different periods is not realistic. It ignores the time value of money.
3. This objective is concerned only with the size of profit and gives no weight to the degree of uncertainty of future profits. Two businesses with varying degree of risk and producing same size of profit is considered similar under profit maximization criterion. Thus, the risk element is ignored, which is one of the most important dimensions of financial management.
4. This objective is incomplete because it ignores the appreciation in the value of securities or firm. Investors and owners of the businessmen are benefited not only by the earning of profit, but also due to the appreciation in the stock price.

  SOME RELATED LINKS  

• Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints | Boumol's Theory of Sales Maximization

• Pricing decision on the basis of Cost Plus Pricing Theory

• Reasons behind aiming at reasonable profit rather than maximum profit by most of firms

• Value of Maximization Theory of Firm | Superiority of Maximization Theory

• H. A. Simon opines that firms aim at satisfying rather than maximizing profit | Simon's Satisficing Theory