Objectives of Firms in Economics
- Excel in Economics
- Jun 5
- 5 min read
In traditional economic theory, firms are assumed to seek profit maximization—that is, they choose output and price so as to make the difference between total revenue and total cost as large as possible. In reality, however, many firms pursue a variety of objectives, sometimes sacrificing profit to achieve other goals.
In this post we’ll:
Explain profit maximization and its mechanics
Survey alternative objectives—revenue, sales, satisficing, ethics, survival
Discuss the principal–agent problem and its implications
Use the prisoner’s dilemma to illustrate strategic pricing
Questions
Evaluate the economic impacts of the 2025 U.S. tariffs on (a) domestic industries and (b) consumers. (15 marks)
Using the data provided, discuss the likely short‑run and long‑run effects of the U.S. government’s 2025 steel tariffs on economic welfare. (13 marks)
1. Profit Maximization
Definition: Profit = Total Revenue (TR) – Total Cost (TC).
A firm maximizes profit by producing the output at which marginal revenue (MR) = marginal cost (MC).
Perfect competition: price-taker, so P=MC=MR
Imperfect competition (monopoly, oligopoly): P>MR=MC, >. Maximize profit where MR=MC
Intuition:
If MR>MC, producing an extra unit adds more revenue than cost ⇒ increase output.
If MC>MR , the extra cost outweighs the extra revenue ⇒ reduce output.
At MR=MC profit peaks.
Break-even and abnormal profit:
Break-even output: price covers average total cost (ATC); economic profit = 0 (normal profit).
Abnormal (economic) profit: positive difference between price and ATC.
Practical caveats:
Identifying the precise MR=MC output can be difficult.
Some firms use cost-plus pricing, marking up average cost by a standard margin—though this may not maximize true profit.
Short-run profit maximization can backfire:
Attracts regulatory scrutiny (e.g. CMA in the UK).
Invites new entrants in lucrative industries.
Strains stakeholder relations if executives reap outsized gains.
May provoke competitive retaliation or takeover bids.
2. Alternative Objectives
While profit remains central, managers often have other targets.
a) Revenue Maximization
Rule: Produce until MR = 0, the point at which total revenue (TR) peaks.
Trade-off: At MR=0 output, MC > MR ⇒ profit is below its maximum.
Why? Higher sales volume can boost market share, satisfy sales-based bonuses, or leverage economies of scale.
Diagram for Revenue Maximisation in economics
The revenue maximizing firm:
Produces where the last unit sold earned the firm no additional revenue (where MR=0)
At every level of output up to this point increases in output caused revenues to rise (MR>0)
At every level of output beyond this point increases in output caused revenues to decrease (MR<0)
Total revenues are maximized where MR=0, but the level of economic profit is smaller than it would be at a lower quantity and higher price (profit maximization).
Elasticity link:
When demand is elastic (PED > 1), MR > 0 ⇒ cutting price raises TR.
At unitary elasticity (PED = 1), MR = 0 ⇒ TR is maximized.
In the inelastic region (PED < 1), MR < 0 ⇒ further price cuts reduce TR.
b) Sales (Volume) Maximization
Goal: Maximize the number of units sold, not revenue.
Rule: Increase output until TR = TC (break-even), but no further—beyond this incurs losses.
Context: Common in diversified firms that can cross-subsidize loss-making divisions (e.g. public service routes funded by profitable urban routes).
c) Satisficing Behavior
Herbert Simon’s concept: firms seek a “good enough” profit and then pursue other objectives.
A coalition of stakeholders (shareholders, managers, workers, consumers) each have demands.
Managers may trade off extra profit to secure job security, fringe benefits, or comfortable work conditions.
Example: a firm accepts lower output/higher cost to invest in employee training or R&D, keeping profits at a satisfactory (but not maximum) level.
d) Loss Minimization and Survival
In severe downturns or following shocks (loss of a major client, economic slump), minimizing losses can be the short-term objective.
Shut-down rule: If price (P) falls below average variable cost (AVC), exit the market.
If P covers AVC but not ATC, a firm may continue operating in hope of recovery.
e) Ethical and CSR Objectives
Pursuing social and environmental goals can form part of a firm’s mission.
Examples:
The Body Shop: early adopter of cruelty-free products and fair-trade sourcing.
Fair-trade coffee/banana exporters: guarantee producers a living wage, even if margins shrink.
While such objectives eat into short-term profits, they can strengthen brand loyalty, mitigate reputational risk, and align with stakeholder values.
3. The Principal–Agent Problem
In large corporations, ownership (principals) and control (agents) are separated:
Principal: shareholders or owners.
Agent: hired managers/CEOs.
Issue: Agents may pursue personal objectives (empire-building, lavish perks) at odds with shareholder profit goals.
Consequences:
Information asymmetry—principals can’t perfectly monitor day-to-day decisions.
Incentive schemes (stock options, performance bonuses) aim to align interests but can also encourage short-termism.
4. Strategic Pricing and the Prisoner’s Dilemma
Game theory shows why rival firms might struggle to sustain cooperative pricing (e.g. cartels).
Prisoner’s Dilemma Setup (adapted for firms):
Rival Keeps Price High | Rival Cuts Price | |
You Keep High | Both earn moderate profit | You lose big share, rival gains |
You Cut Price | You gain share (short-term) | Price war ⇒ both earn low profit |
Even though mutual high prices yield the best collective outcome, each firm has an incentive to undercut, leading to a sub-optimal “price war” equilibrium.
Conclusion
Firms are multi-faceted organizations balancing profit, growth, market share, stakeholder satisfaction, and ethical concerns.
While profit-maximizing underpins much of economic theory, real-world managers often pursue a richer blend of objectives—shaped by regulatory constraints, internal incentive structures, and broader social pressures.
Understanding this spectrum of goals helps explain diverse behaviors across industries and the strategic choices firms make in pricing, output, and investment.
Questions to think about
IB Economics 10-Marker Questions
(Typically Section B short-answer/quantitative and data-response questions on “Objectives of Firms”)
“Explain,” with the help of a diagram, how a profit-maximizing firm chooses its output where MR = MC.
Command term: Explain
Focus: Price, output, profit difference, consumer vs. producer surplus
“Discuss” two reasons why a firm might choose revenue maximization instead of profit maximization.
Command term: Discuss
Focus: Market share, managerial incentives, elasticity, long-run strategy
“Calculate and comment” on the change in total revenue if a monopolist increases output from the profit-maximizing level to the revenue-maximizing level.
Command term: Calculate and comment
Focus: MR = 0 output, revenue before vs. after, brief evaluation of profit trade-off
IB Economics 15-Marker Questions
(Typically Section B longer data-response or Section C essay questions on “Objectives of Firms”)
“Evaluate” the trade-off between profit maximization and corporate social responsibility for a large multinational.
Command term: Evaluate
Scope: Producer gains vs. ethical costs, brand value, stakeholder reactions, DWL
“To what extent” do satisficing objectives explain why some firms maintain high prices even when they could reduce costs to increase profit?
Command term: To what extent
Scope: Principal–agent problem, managerial goals, consumer expectations, competitive pressures
“Assess” the implications of loss minimization as a short-term objective for a firm facing an industry downturn.
Command term: Assess
Scope: Shut-down rule (P < AVC), survival strategies, impact on investment and long-run viability
CIE 9708 Economics 13-Marker Questions
(Paper 2 style extended responses for Cambridge International A-level: “Objectives of Firms”)
“Using a diagram and data, discuss the effects on consumer surplus, producer surplus and deadweight loss when a firm shifts from profit maximization to revenue maximization.” (13 marks)
Command term: Discuss
Focus: TR and profit changes, market share, elasticity, dynamic effects
“Explain and evaluate” how the principal–agent problem can lead to a divergence between stated profit targets and actual managerial behavior. (13 marks)
Command term: Explain and evaluate
Scope: Information asymmetry, incentive schemes, conflict of interest, performance outcomes
“Examine and recommend” which objective—profit maximization, satisficing, or CSR—would be most appropriate for a firm in a highly competitive industry, and why. (13 marks)
Command term: Examine and recommend
Scope: Criteria for choice, trade-offs, stakeholder impacts, long-term sustainability
