AQA A-level Economics: Market structures and the objectives of firms (7136)

The material here is aligned to the AQA AS and A-level Economics specification, version 1.3 dated 29 June 2022, for teaching from September 2015. It covers two parts of the sub-section called Perfect competition, imperfectly competitive markets and monopoly: 3.1.5.1 Market structures and 3.1.5.2 The objectives of firms. The combined PDF prints the A-level versions as 4.1.5.1 and 4.1.5.2. All firms, markets and figures are made up and illustrative.

Pair it with the revision notes and the practice set. Wider links: the AQA A-level Economics hub, a checklist you can print, the 10-minute diagnostics and an overview of the whole individuals, firms and markets block.

Outcomes at a glance

Section	Outcome
3.1.5.1 Market structures	The spectrum from perfect competition to pure monopoly; the number of firms, the degree of product differentiation and ease of entry as the factors that distinguish structures
3.1.5.2 The objectives of firms	Profit maximisation as the assumption of traditional theory; the rule MC=MR; the reasons for and consequences of a divorce of ownership from control; other objectives (survival, growth, quality, sales revenue, market share); the satisficing principle

The detailed models of each structure belong to other units, so this guide stops at classification and objectives.

3.1.5.1 Market structures

Economists do not sort markets into four sealed boxes. They place them along a spectrum. At one end is perfect competition, at the other is pure monopoly. Real markets sit between the two. Three factors decide where a market lies.

1. Number of firms. Many small firms push towards perfect competition. One firm is a pure monopoly.
2. Degree of product differentiation. Identical (homogeneous) products push towards perfect competition. Products that buyers see as different give each firm some control over its own price.
3. Ease of entry. Free entry and exit push towards perfect competition. Barriers to entry, such as a licence or a very large start-up cost, push towards monopoly.

Structure	Number of firms	Product	Entry	Price-setting power
Perfect competition	Very many	Identical	Free	None: price taker
Monopolistic competition	Many	Differentiated	Easy	Small
Oligopoly	A few large firms	Identical or differentiated	Significant barriers	Considerable
Pure monopoly	One	No close substitute	Blocked	Largest

The pattern in the last column follows from the other three. The fewer the rivals and the weaker the substitutes, the less a price rise loses a firm customers, so the more control it has.

Worked example: placing four markets

Four fictional markets are described below.

Market	Description	Best placement
W	800 farms, each with under 1% of sales, selling identical grain; anyone can start growing	Close to perfect competition
X	40 cafes in a town, each with a different menu and atmosphere; a small cafe is cheap to open	Monopolistic competition
Y	3 firms hold 85% of sales (40% + 30% + 15%); a new entrant needs a very large factory	Oligopoly
Z	One firm supplies a town’s water under a legal licence	Pure monopoly

Notice what a good answer does. It names the structure and then points to the evidence from all three factors. Market W has many firms, identical goods and free entry, so all three point the same way. Market Y has a high combined share and a barrier, so it fits oligopoly even though there are three firms rather than two.

3.1.5.2 The objectives of firms

Profit maximisation and MC=MR

Traditional models assume each firm is trying to make as much profit as possible, with profit defined as total revenue (TR) less total cost (TC). Marginal revenue (MR) is what one extra unit sold adds to revenue. Marginal cost (MC) is what making that unit adds to cost.

The profit-maximising rule is to produce where MC = MR. The reasoning runs unit by unit.

• If MR is greater than MC, the next unit adds more to revenue than to cost, so profit rises. Produce it.
• If MC is greater than MR, the next unit adds more to cost than to revenue, so profit falls. Do not produce it.
• Profit is highest at the output where the two meet, with MC rising through MR from below.

On a diagram with output on the horizontal axis and revenue and cost on the vertical axis, MR slopes down (for a firm facing a downward-sloping demand curve), MC is U-shaped, and the profit-maximising output is read down from where MC cuts MR from below. The price is then read from the demand curve (average revenue) above that output.

Worked example: Firm A

Firm A is a fictional regional biscuit maker. Its demand is P = 80 − 2Q and its total cost is TC = 50 + 8Q + Q², where Q is thousands of packs per month, P is in pounds per pack and money totals are in thousands of pounds. Marginal values below are the change from the previous unit.

Q	P	TR	MR	TC	MC	Profit
10	60	600	42	230	27	370
11	58	638	38	259	29	379
12	56	672	34	290	31	382
13	54	702	30	323	33	379
14	52	728	26	358	35	370

For the 12th unit, MR (34) exceeds MC (31), so it adds 3 to profit. For the 13th, MC (33) exceeds MR (30), so it takes 3 away. Profit peaks at Q = 12: price £56, TR £672 thousand, TC £290 thousand, profit £382 thousand. With the algebra, MR = 80 − 4Q and MC = 8 + 2Q, so 80 − 4Q = 8 + 2Q gives Q = 12.

Divorce of ownership from control

In a small firm the owner often runs the business and wants profit. In a large company the owners (shareholders) and the people running it (managers) are different groups. This is the divorce of ownership from control.

Reasons it happens

• As a firm grows it needs more capital, so it sells shares to many investors, each holding a tiny fraction.
• Limited liability makes shareholders willing to hold shares without managing.
• Running a large organisation needs specialist managers.
• With ownership dispersed, no single shareholder can easily supervise the managers.

Consequences. Managers (the agents) know more about the firm than shareholders (the principals), and their interests differ. Shareholders want profit and dividends. Managers may want a higher salary, status, a bigger firm or a quiet life. This is the principal-agent problem. Managers may then pursue sales revenue, growth or perks instead of maximum profit.

Effect on objectives, conduct and performance

• Objectives shift towards growth and sales revenue, which raise managers’ pay and prestige.
• Conduct changes: more takeovers and expansion, heavier spending on staff benefits and offices, and a preference for steady results over risky projects.
• Performance may suffer: costs are higher than necessary, so profit and the return to shareholders are lower.

Controls pull the other way. These include pay linked to profit or share price, share options for managers, annual votes by shareholders, and the threat of takeover if the share price is poor. Divorce can also help: skilled managers may run the firm better than the founders did, and they may take a longer-term view.

Worked example: managers choose revenue

Suppose Firm A’s managers are paid mainly on sales. Total revenue peaks where MR reaches zero. With MR = 80 − 4Q, that is Q = 20, P = £40, TR = £800 thousand, TC = £610 thousand and profit only £190 thousand. Shareholders insist on at least £300 thousand profit. Profit is £307 thousand at Q = 17 and £274 thousand at Q = 18, so managers expand to Q = 17.

Objective	Q	P	TR	Profit
Profit maximisation	12	56	672	382
Revenue maximisation with a £300 thousand profit floor	17	46	782	307
Unconstrained revenue maximisation	20	40	800	190

The managerial objective costs shareholders £75 thousand of profit but gives customers more output (17 against 12 thousand packs) at a lower price (£46 against £56). Whether that is good or bad depends on who you ask. This two-sided view is useful in evaluation.

Other objectives

• Survival. In a recession or against a strong rival, a firm may aim only to cover its costs and stay in business.
• Growth. Larger firms gain economies of scale, market power and more secure managers. Growth may be financed by reinvesting profit, so it can lower current dividends.
• Quality. A reputation for quality supports loyalty and a higher price, but quality raises costs.
• Sales revenue maximisation. The rule is MR = 0, as in the example above. It gives a higher output and a lower price than profit maximisation (provided MC is positive).
• Market share. Share of the market is the firm’s sales divided by total market sales. If Firm A’s market is 240 thousand packs a month, 12 thousand packs is a 5.0% share and 17 thousand is 7.1%.

Quality in numbers. Suppose Firm A raises quality. Demand becomes P = 84 − 2Q and costs become TC = 50 + 18Q + Q². MR = MC gives 84 − 4Q = 18 + 2Q, so Q = 11, P = £62, TR = £682 thousand, TC = £369 thousand and profit £313 thousand. Profit falls by £69 thousand, yet price is higher and quality has improved. A firm with a quality objective may accept this. A pure profit maximiser would not.

The satisficing principle

Satisficing means aiming for a satisfactory outcome rather than the maximum. Managers rarely know their exact MC and MR curves, they answer to several groups (shareholders, staff, customers), and they cannot compute the best output. They set targets and stop looking once these are met. With a profit target of £250 thousand, any output from 6 to 18 thousand packs works for Firm A, so there is no pressure to find 12. Satisficing therefore predicts less intense profit-seeking than the traditional model.

Evaluating the objectives

A balanced answer links the objective to the context.

• Profit maximisation remains a useful benchmark. It is a clear prediction, and shareholders, takeover threats and competition keep many firms close to it.
• It is hard to test, because firms do not publish MC and MR, so actual behaviour may be satisficing.
• Which objective applies depends on ownership structure, firm size, how long managers expect to stay, how competitive the market is and the economic climate.
• Short-run sacrifices may serve long-run profit. Spending on quality or market share may raise profit later, so the objective and the motive can be hard to separate.

Common errors

• Writing that a firm should produce where MC = MR “because that is where cost is lowest”. It is where profit is highest.
• Reading the price from the MR curve. Price comes from the demand (AR) curve at that output.
• Treating a divorce of ownership from control as automatically harmful. State the problem, then the controls and the benefits.
• Giving revenue maximisation as MR = MC. It is MR = 0.
• Describing satisficing as “making no profit”. It means a sufficient profit.
• Describing the structure from one factor only. Use all three.

Official syllabus

Source: the AQA AS and A-level Economics specification (the combined document for the AS and the A-level), version 1.3, 29 June 2022. Content taught here: 3.1.5.1 and 3.1.5.2, which the PDF prints as 4.1.5.1 and 4.1.5.2.