In the analysis of market structure, it was assumed that firms set out to maximise profits. However, as I said in an article at the very beginning of this revision blog, firms may set out to achieve other objectives. The price of a firm’s product is a key strategic variable that may be manipulated in order to attain whatever objective the firm wishes to achieve.
The diagram above illustrates the variety of pricing rules that are possible. The figure shows a firm that is not operating under perfect competition, as it faces a downward sloping demand curve for its produce, shown by AR = D.
If the firm chooses to maximise profits, it will choose output such that MR = MC, and will then set the price to clear the market. This is because, when the revenue gained from making another unit is less than the cost of producing it, total revenue will increase a greater amount than total costs, meaning profit will increase. Output will therefore be set at Qp, price at Pp.
The economist William Baumol argued that, if there is a divorce of ownership from the control in the organisation of a firm, whereby the shareholders have delegated day-to-day decision making to managers (a principal-agent situation), the managers may find themselves with freedom to pursue other objectives, such as revenue maximisation. A revenue maximiser would choose to produce where MR = 0. This is because if marginal revenue is greater than 0, more revenue is still able to be made from an increase in output. At the level that MR = 0, an increase in output would only lower total revenue, due to the downward sloping AR and therefore MR curve. This means that output would be set at Qr, and price at Pr.
If instead managers set out to maximise the volume of sales subject to covering opportunity cost, they will choose to set output at such a level such as price equals average cost, which will clear the market. Any lower than this, and the total cost of producing the goods becomes more than the price of the total sales, so a loss is made.
Allocative efficiency is achieved when the value consumers place on a good or service (reflected in the price they are willing to pay) equals the cost of the resources used up in production. This occurs where price is equal to marginal cost – where the social welfare is the highest. The market clearing output at this price is therefore where MC = AR, so Q = Qa and P = Pa = MC.