A2 ECONOMICS (MICRO)

CHAPTER Alan
5: Objectives, Price discrimination and Contestable markets

The primary objective of a firm is to maximize profits, in order to do that firms, produce
where MR=MC. However, sometimes firms may not maximize profits and may have other
objectives.

Why do firms have objectives other than profit maximization?

1) Sometimes it is difficult to achieve profit maximization as they are unable to calculate
MR and MC as they fluctuate quite a lot due to exogenous factors that are not in the
firm’s control.
2) Firms avoid maximizing profits to avoid government scrutiny as higher prices would
result in increase in the amount of taxes, which leads to a decrease in the firm’s
power.
3) Firms may also want to diminish the incentive of new firms entering the market by
avoiding making profits.
4) High profits may disrupt firm’s relations with customers and workers as customers
prefer the price of goods and services to be relatively low and workers would demand
increment in wages as profits increase.
5) Principle agent problem is created. This is a conflict in priorities between a person or
group and the representative authorized to act on their behalf. For example,
managers may pursue other aims than profit maximization which might be the
owners aim.

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
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Other objectives of firms include:
1. Sales revenue maximization: This is a Cost/revenue
process where MR=0. This is done to
maximize firms market power and
shares and as sales increase the
manager’s wages/ payoffs increase as MC
well. quantity) me

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2. Output maximization: this refers to the
production of as much output that is
AC

profitable. Where AR=AC. This is used to

raise market share and reduce the level C
D
of competition.
3. Efficiency/cost minimization: produce B
where AC=MC. This reduces wastage D=AR

and increases efficiency.

4. Satisficing: This involves reaching a
A
satisfactory level of outcome which is
shown by the minimum possible level of
output that can be achieved by one
E
objectives and moving to the next so
that other objectives are also achieved.
MR
For example, minimum level of Quantity Q1 Q4 Q2 Q5 Q3
satisfactory profits which managers
must earn, after which it is up to them A: MR=MC (profit maximization) – Q1
to pursue whatever other objective that
is more likely to improve the B: AC=MC (cost minimization) – Q4
performance and image of the firm. C: P=MC (marginal cost pricing) – Q5
5. Marginal cost pricing: P=MC. Normally
this is pursued by government for public D: AR=AC (output maximization) – Q3
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to give relief to private sector. E: MR=0 (sales maximization) – Q2

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
 Price discrimination vs Price differentiation.

Price discrimination Price differentiation

Price discrimination is a situation in which Price differentiation refers to when there is
either the producer sells a good to different difference in product pricing due to
buyers at two or more prices, or when the differences in cost of production. Therefore,
same consumer is charged different prices in this case differences in prices is due to
for the same product for reasons not the production cost not the consumer
associated with cost differences. For
example, different electricity charges for
domestic and commercial users, different
park ticket prices for general public and
senior citizens/students etc.

☒ Methods of price discrimination:

1) By Time: Different price levels at different times
2) BY geography: Different price levels in different areas
3) By use: for example, differences in price levels for commercial and domestic use.
4) By person: for example, general public vs elderly.

Conditions for price discrimination:

1) Firms must be prices makers. Therefore, perfectly completive firms cannot discriminate
whereas monopolies can make use of it.
2) Firms must be able to separate the two markets i.e. domestic consumers cannot resale
products at higher prices to commercial users.
3) Different markets must have different elasticities. In inelastic markets prices are to be
set higher for the same product as compared to elastic markets. (diagram in class page
134)

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What monopolies do is indulge in perfect price discrimination. This is when they charge
where P=WTP, which means that they capture the entire consumer surplus and convert it
into producer surplus.
Degrees of price discrimination

* First degree: In a perfect business world, companies would be able to eliminate all consumer surplus through first-degree
price discrimination. Also called personalized pricing or perfect price discrimination, this strategy occurs when businesses
can accurately determine what each customer will pay for a specific product or service and then sell it for that price.
* Second degree: the ability to gather information on every potential buyer is not present. Instead, companies
price products or services differently based on the preferences of various groups of consumers. E.g. bulk
buying discounts, loyalty cards for frequent customers etc.
* Third degree: the ability to gather information on every potential buyer is not present. Instead, companies price products
or services differently based on the preferences of various groups of consumers. E.g. different pricing for elderly or
children in parks or planes tickets

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
 Advantage vs disadvantages of price discrimination:

Advantages Disadvantages
1) Helps monopolies earn some profits 1) High demand of some consumers
in the markets that have very high may be exploited by charging high
costs which cannot be covered by prices.
charging similar prices. 2) Monopoly can eliminate any
2) It can be used to provide relief to consumer surplus which makes
the less fortunate citizens in the consumers worse off.
society, for example, poor or senior
citizens.
3) It allows monopoly to operate even
in remote places where it is facing
losses which it covers by charging
higher prices at other places.

Contestable markets: these are markets which have very low/negligible barrier to entry. Its
major characteristics are:
1) There are very low barriers to entry. It is assumed that in contestable markets, there
are no sunk costs, which are the main barriers in any market.
2) Firms compete with each other and they do not collude.
3) Each firm has a negligible market share.
4) Products maybe identical or differentiated.
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✓5) A unique feature of contestable markets is the idea of perfect competition. Since
there are few barriers to enter, there is always a threat of further competition from
potentially new firms. This is the reason why prices are kept quite low in contestable
markets.

Note: Contestable markets can exist in any of the four market structures that we have studied
in chapter 3, i.e. perfect competition, monopolistic competition, oligopoly and even monopoly,
though barriers will be high, with sunk costs still zero.

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
 Normal vs perfectly contestable markets:

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-

Mc

In perfectly contestable markets, due

AC
to no barriers to entry price is kept
where P=AC and firms earn normal
Pi
profits.
However, perfectly contestable
markets do not exist as even though
:# D=AR
there are no sunk costs, but there still
are some other barriers to entry,
Supernormal
which means that although prices are
still low, they are still greater than the
profits .

Q ,
Qo
MR
&
average cost. (P>AC) and hence they Perfectly contestable market earning normal
make some small amounts of profits as P=AC, producing at q0.
abnormal profits. MC
Contestable markets do not produce
where MR=MC. This is because of
potential competition. They keep
their prices artificially low so that Pm f-Ac
there is little to no incentive for new
firms to enter. Therefore, they Pam is / *
I
produce more output than imperfect
markets. Therefore they can prices D=AR
slightly above where demand and AC
intersect
Qm Qcm
MR
This price in the diagram is Pcm which is lower
than profit maximising monopoly price, while its
Normal contestable market earning super
output is Qcm which is higher than the profit normal profits as P>AC, producing at q0.
maximising monopoly output

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
Perfectly competitive firm vs monopolistically competitive firm (full and excess capacity)

LRMC
LRAS

In monopolistic completion there is excess

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capacity in the long run.

m.g
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Perfectly competitive firms earn normal PE
profits, so do monopolistically competitive
firm’s prices are set where they are equal to P = AR = MR
average cost i.e. P=AC.

However, perfectly competitive firms

produce at full capacity in the long run or
utilize strategy of efficient output by setting
Q0
price where MR=AR =LRMC=LRAC.
Perfectly competitive firm. Full capacity at q0.
This is not true in the case of
monopolistically competitive firms where

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(P=AR= LRAC)>(MR=LRMC).
LRMC
Thus, a monopolistically competitive firms

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output is less than a perfectly competitive
firms output, but its price is higher.
LRAC
P0

AR=D .

%
Q0 QE

MR me
to
Monopolistically competitive firm produces
where P=AC at Q0, while perfectly competitive
market’s output is where P = MC = AC at QC
Thus the gap between Q0 & Q•E is the excess
capacity at which monopolistically competitive
firm produces, which shows inefficiency in
monopolistic competition

SOHAIB ARSHAD ALAVI [email protected] Typed by Azqa Imtiaz

LGS Gulberg A levels 2018-20
 Typescfcompetition
→
P#tition Non-primary
discussed 1) Ads promo campaign
: -

Already to ↑ demand
how
firms competewet 2) Afteesaleservices
eg delivery refund
with eachother >

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prices 3) Quality &
assurance

( kinked demand ,
conteshidemkts perfect 4) Packaging 'm
goods
>

&
monopolistic comp etc
,
placing of stores
predatory pricing ) different utility