Cartels and objectives

of firms
 Cartels
• As referred to earlier when considering oligopoly, a cartel is a formal
agreement between member fi rms in an industry to limit competition.
• Th e agreement may involve fixing the quantity to be produced by each
member or fixing the price for which the product is sold. Other
restrictions may also be applied.
• A cartel maximises profits in the same way as a monopolist
 The long-term survival of a cartel depends
upon
• the high barriers to entry.
• However, there are threats to a cartel, such as:
• ■ The possibility of a price war, whereby one firm breaks rank to capture a bigger market
share.
• ■ If some members have higher costs than others, resulting in fewer profits due to the
agreed fixed price.
• ■ If there is no dominant member that has the power to control others.
• ■ Legal obstacles such as in the EU and USA where cartels are illegal since they restrict
competition and do not act in the best interests of consumers.
Differing objectives of a firm
 Profit Maximizing
• If the firm produces up to the point where the cost of making the last unit is
just covered by the revenue from selling it, then the profit margin will have
fallen to zero and total profits will be at their greatest.
• A fi rm making the minimum level of normal profit is said to be producing at
the break-even output.
• No abnormal profit is being made. Most fi rms, though, will want to make
abnormal profit as a reward for taking risks.
• If the fi rm produces up to the point where the cost of making the last unit is
just covered by the revenue from selling it, then the profit margin will have
fallen to zero and total profits will be at their greatest.
Revenues
and Costs Profit Margin

MC

MR>M
C MC>MR Loss on Each
Successive unit
MR
Q Quantity
• a firm producing an output to the left of Q is sacrificing potential profit.
• It can raise total profit by increasing its output, because each further unit sold adds more to revenue
than it does to costs.
• A firm producing to the right of Q is making a loss on each successive unit, which will lower the total
profit.
• It would be better off cutting output back to Q where MC = MR and the area of abnormal profit will
be maximised.
• There may be several reasons why firms do not operate at the profit maximisation output
• In practice, it is difficult to identify this output.
• The firm may simply work out the average total cost and then add on a standard profit margin in
order to determine the selling price.
• This cost-plus pricing technique may not result in maximum profit.
 ■ Short-term profit maximisation may not be
in the long-term interest of the company since:
• firms with large market shares may wish to avoid the attention of government watchdog
bodies, such as the Competition and Markets Authority in the UK and the US Justice
Department
• large abnormal profit may attract new entrants into the industry
• high profits may damage the relationship between the firm and its stakeholders, such as
its consumers and the company workforce as they may see senior managers and
shareholders earning large returns
• profit maximisation may not appeal to the management, who may have different
objectives – high profits might trigger action by the firm’s rivals and it could become a
target for a takeover bid.
 Other objectives of firms
• Dissatisfaction with the traditional assumption of profit maximisation has
led to a number alternative objectives being put forward to explain how
firms behave.
 Sales revenue maximisation
• The reason why sales revenue maximisation might be chosen in a large fi
rm is that management salaries might be linked to the value of sales.
• Shareholders might be more interested in profit.
• The solution to this conflict of interests is to offer management some
shares as a bonus or to link their salaries to profits.
Firm having revenue maximization as an objective determines its output @ MR= 0

TR

Quantity
Revenue PED >1

PED = 1

PED < 1
AR = D
Q MR = 0 Quantity
 Sales maximization
• This option maximizes the volume of sales rather than the sales revenue.
• In sales maximization the firm would increase output up to the break-even output where the
total revenue just covered the total cost.
• A higher output than this implies loss-making behavior.
• The only situation where this would be possible is where the firm could use the profit from
some other activities to cover these losses.
• This is referred to as cross-subsidisation.
• It could be that a state-owned firm, such as one running local bus services, uses the profits
from city services to retain lower density routes that are loss-making.
• A firm in the private sector would not go beyond the breakeven output in
order to expand sales unless it is part of a diversified grouping where cross-
subsidisation is being practised.
• If it did, then it would be making fewer profits.
• However, deliberately cutting the price to reduce profit might be a strategy to
deter new entrants into the market.
• This was referred to earlier as predatory pricing.
• If new entrants still appear, a price war may be a tactic to squeeze them out.
 Satisficing
• Satisficing occurs when a firm seeks to make a reasonable level of profits, sufficient to satisfy the
shareholders but also to keep the other stake-holding groups happy, such as the workforce and, of course,
consumers.
• The firm is seen as a coalition of interest groups, each with its own objectives, which may change over time.
• Workers will expect pay rises and improvements in working conditions which may raise costs.
• Consumers may expect to see prices falling, particularly if there are rival producers.
• This is a long way from the simple profit-maximising theory as firms may choose to sacrifice some potential
short-term profits to satisfy these expectations.
• Satisficing can also be a feature of firms that have enjoyed a high market share over a long period of time.
• An example might be a fi rm that produces blank VHS tapes and nothing else and which fi nds its core
product now obsolete.
 Loss minimisation
• In some situations fi rms may have a short-term objective of minimising
losses.
• This is most likely to be where a fi rm is facing serious unexpected
external threats such as the loss of its best customer or a downturn in the
economy due to some external shock.
• Survival in such circumstances becomes a priority in order to allow the fi
rm to develop a revised strategy to stay in business.
• If a firm is not covering its variable costs, then closure would seem to be
the only sensible outcome.
• If variable costs (but not total costs) are being recouped, then it is possible
for the firm to continue in business a little longer so that it can try to map
out a retrieval strategy.
• In the UK, for example,
• retailers of fashion clothes,
• electrical goods,
• books and music products have been badly affected by the growth of
Internet sales.
• Not all have been able to implement a successful retrieval strategy.
 Ethical objectives
• In some respects satisficing can be viewed as an ethical objective for a
firm to pursue as the pursuit of maximum profit is not always in the best
interests of society.
• Much wider is the notion of corporate social responsibility and why many
firms now incorporate aspects in their mission statements.
• An important consideration here is the growing number of cases where
unscrupulous fi rms appear to put self-interest before the wider interest of
others.
 Typical examples are:
• ■ the growing instances of serious damage to the natural environment caused by firms,
resulting in pollution, the loss of renewable resources and damage to the natural habitat
• ■ the exploitation of child and adult labour, particularly in the production of clothing in
developing economies
• ■ exposing workers to serious health risks in the production of toys and consumer goods
• ■ paying poor farmers in developing economies low prices for their produce.
• It is within this context that a growing number of firms have stepped back from the
endless pursuit of profit and sought to have a more responsible attitude to how what they
are selling is sourced and produced.
 Examples
In the UK of an ethically focused firm is
The Body Shop, which has sought to bring sustainable products to its
customers worldwide.
It has also been at the forefront of supporting many environmental projects,
animal welfare initiatives and educational programmes in developing
economies.
Other examples are banana exporters and coffee, tea and cocoa manufacturers
who only source from fair trade farmers and suppliers.
• It can be argued that ethical objectives eat into profits.
• This is so. The danger all firms face is that consumers could react very
unfavorably to purchasing products that come from unethical sources of
supply.
• Given this risk, the cost of promoting corporate social responsibility is
often a small price to pay.
 The principal agent problem
• In setting the various objectives of firms it is assumed that those who set these
objectives have the authority and ability to do so.
• For example, in order to pursue an objective of profit maximisation, managers must
be able to determine the price and output.
• The problem is that, in large firms especially, there is a divorce between management
and ownership; shareholders and other owners are invariably not in a ‘hands on’
position in the firm to really know whether the decisions being taken are the right
ones in relation to stated objectives.
• This issue is known as the principal agent problem.
• The ‘principal’ is the owner who hires an ‘agent’ to run a business in return for a salary and the
usual fringe benefits and bonuses that go with it.
• There is a case of information failure since the principal is unable to ensure that the appointed
agent is taking the necessary decisions to run the fi rm in the best interests of owners and
shareholders.
• This could mean, for example, that the agent is following an objective of satisficing when the
principal believes he or she is implementing a policy of profit maximisation. The risk is that the
agent has his or her own agenda, essentially ignoring the wishes and best interests of the principal.
• The principal’s intended objective for the firm is therefore not being implemented and it inevitably
leads to friction between the two parties.
• There have, for example, been a number of disputes in the designer fashion business where the
head of design’s ideas for the business have not coincided with those of the company’s board and
shareholders.
• These usually surface when a firm is losing market share or is receiving critical reviews in the
media.