OxfordAQA International AS and A-level Economics: Objectives and growth of firms (9640)

This guide follows the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2 (first A-level exams May/June 2022). It covers sections 3.3.1.3 (the objectives of firms) and 3.3.1.4 (the growth of firms). Section 3.3 is extra International A2 content, assessed in Unit 3, and the specification expects you to use the knowledge and skills you developed in Unit 1 to support Unit 3. All figures below are invented for teaching and are not real statistics.

Related pages: revision notes, practice questions, Operation of Markets guide, exam preparation, the course hub, the checklist and the free diagnostics.

What you must be able to do

Section	Outcome
3.3.1.3	Explain why traditional theory assumes profit maximisation; explain when a profit-maximising firm produces in the short run and the long run
3.3.1.3	Give reasons for a divorce of ownership from control and assess its consequences
3.3.1.3	Discuss aims such as market share, revenue, quality, growth and survival; apply the satisficing principle; show how state ownership or control alters objectives
3.3.1.3	Explain how objectives affect price, output and other conduct and performance
3.3.1.4	Explain how and why firms grow; contrast internal (organic) and external growth (mergers and takeovers)
3.3.1.4	Explain vertical, horizontal and conglomerate integration, with their benefits and costs

3.3.1.3 The objectives of firms

Profit maximisation

Traditional theory of the firm assumes that firms aim to maximise profit. Profit is total revenue (TR) minus total cost (TC). Profit is highest where marginal revenue (MR) equals marginal cost (MC) and MC is rising through MR from below. Producing a unit that adds more to revenue than to cost raises profit; producing one that adds more to cost lowers it.

Worked example (Country A, illustrative). A small workshop makes hand-finished lamps. Demand is P = 70 − 0.5Q, so MR = 70 − Q. Total cost is TC = 1,000 + 10Q + 0.1Q², so MC = 10 + 0.2Q (£ per week).

Set MR = MC: 70 − Q = 10 + 0.2Q, so 60 = 1.2Q and Q = 50 lamps. Then P = 70 − 25 = £45, TR = 45 × 50 = £2,250 and TC = 1,000 + 500 + 250 = £1,750. Profit = £500.

Q	P (£)	TR (£)	TC (£)	Profit (£)
30	55	1,650	1,390	260
40	50	2,000	1,560	440
50	45	2,250	1,750	500
60	40	2,400	1,960	440
70	35	2,450	2,190	260

Profit rises to Q = 50 and then falls, which confirms the MR = MC result. Costs include normal profit, so £500 is supernormal (abnormal) profit.

Short-run and long-run production

A profit-maximising firm will produce in the short run if revenue covers its variable costs, because the surplus over variable cost (the contribution) helps to pay fixed costs that must be paid anyway. It will produce in the long run only if it can make at least normal profit, because every cost then becomes avoidable.

Worked example (Country B, illustrative). A laundry has fixed costs of £900 a week and variable cost of £3.00 per load. It washes 400 loads.

• Price £4.50: TR = £1,800, variable cost £1,200, contribution £600. Loss = 600 − 900 = £300. Shutting down loses £900, so it keeps going.
• Price £2.50: TR = £1,000, variable cost £1,200, contribution −£200. Loss = £1,100, worse than £900, so it shuts down.
• Long run: average cost = 900 ÷ 400 + 3.00 = £5.25. Below this price the owner earns less than normal profit and exits.

Other objectives

Firms have a range of possible objectives, and each changes price, output and conduct differently. Using the lamp workshop:

Objective	Rule	Q	P (£)	Profit (£)
Profit maximisation	MR = MC	50	45	500
Sales revenue maximisation	MR = 0	70	35	260
Output maximisation with normal profit only	AR = AC	about 78.9	about 30.6	0

At the revenue-maximising output, price elasticity of demand is unitary: PED = (1 ÷ 0.5) × (35 ÷ 70) = 2 × 0.5 = 1 in absolute value. The firm gives up £240 of profit (500 − 260) for £200 more revenue (2,450 − 2,250).

Survival matters in a recession or when a rival enters: the firm may cut price to cover variable cost. Growth and market share may justify low prices now to build scale or deter entry. Quality may raise costs and price but build loyalty. Firms may also pursue ethical, environmental or employee-welfare aims, or managers may seek status. In each case, say what happens to price, output and profit, and whether the aim can be sustained.

Satisficing

Satisficing means aiming for a satisfactory outcome, not the maximum. Managers or owners set a target, such as a minimum profit, and then pursue other aims once it is met.

Suppose the lamp owner is content with £400 a week. Profit = 60Q − 0.6Q² − 1,000, which is at least £400 for Q between about 37.1 and 62.9. The owner could choose 62 lamps (profit 60 × 62 − 0.6 × 3,844 − 1,000 = £413.60), selling more and holding a larger share, while still hitting the target. This helps to explain why real firms do not always choose MR = MC: information is incomplete, and the cost of finding the exact optimum may exceed the gain.

The divorce of ownership from control

In a large company the owners (shareholders) are separate from the managers who run it.

Reasons: growth needs more capital than a few owners can supply, so shares are sold to many people; limited liability makes it easier to raise finance; running a large firm needs specialist managers; and each small shareholder has little incentive to monitor managers.

Consequences: shareholders (the principals) want profit and dividends, while managers (the agents) know more about the firm (asymmetric information) and may prefer pay, status, security, growth or sales. Suppose the lamp manager earns a bonus of 2% of revenue. At Q = 50 the bonus is £45; at Q = 70 it is £49. Gaining £4 costs shareholders £240 of profit, so the incentive is poorly aligned. A bonus of 2% of profit pays £10 at Q = 50 and £5.20 at Q = 70, so it rewards the shareholders’ aim.

Shareholders can respond with profit-linked pay, share options, independent directors, voting at the annual meeting, and the threat of takeover if poor performance lowers the share price. Evaluate: managers may take a longer view than impatient shareholders, and professional managers may raise efficiency.

Government ownership and control

A publicly owned firm may be asked to pursue objectives other than profit, such as universal service, employment or low prices, so its price and output differ from a private firm’s.

Worked example (Country C, illustrative). A state bus company has demand P = 10 − 0.002Q (Q is trips a day), marginal cost £2 per trip and fixed cost £6,000.

Objective	Q	P (£)	Profit (£)
Maximise profit (MR = MC)	2,000	6	2,000
Break even (AR = AC, the larger of two such outputs)	3,000	4	0
Price equal to MC	4,000	2	−6,000

At P = MC the loss is 8,000 − 14,000 = £6,000, so a subsidy is needed. Evaluate: low prices help low-income users and may reduce external costs such as congestion, but a guaranteed subsidy can weaken the incentive to control cost, and political aims can change with each government.

3.3.1.4 The growth of firms

How and why firms grow

Organic (internal) growth means expanding with the firm’s own resources: new products, new sites or more sales, often funded by retained profit. If turnover rises from £20m to £23m, growth is (23 − 20) ÷ 20 × 100 = 15%. It is slower but keeps control and culture intact. External growth means joining with another firm by a merger (agreed combination) or a takeover (acquiring control, sometimes against the target’s board).

Reasons for growth: economies of scale and lower average cost; greater market power; spreading risk; new markets; survival; and managers’ wish for status or pay.

Horizontal integration

Horizontal integration joins two firms that sell the same kind of product at the same stage of production. Worked example (Country D, illustrative). In a market worth £400m, Firm R sells £72m (18%) and Firm S sells £56m (14%). Together: 128 ÷ 400 = 32%. Firm R produces 6m units at a total cost of £54m (£9 per unit) and Firm S makes 5m units for £44m (£8.80). Joint cost is £98m, or £8.91 per unit. If merging removes £5m of duplicated overhead, cost falls to £93m ÷ 11m = £8.45 per unit.

Benefits: scale economies, less competition and more bargaining power. Costs: higher prices, less choice, possible diseconomies of scale and regulatory challenge.

Vertical integration

Firms at different stages join. Backward integration buys a supplier; forward integration buys a distributor. A furniture maker buys timber for each of its 10,000 units a year at £60, of which £12 (20%) is the supplier’s margin. Owning the supplier cuts the cost to £48, saving £12 × 10,000 = £120,000 a year. Benefits: secure supply, lower cost, quality control. Costs: reduced flexibility, being tied to an inefficient unit, and possible foreclosure of rivals.

Conglomerate integration

Firms in unrelated markets join, mainly to spread risk. In Country E, profits (£m) over four years are Firm F: 12, 4, 14, 6 and Firm G: 4, 12, 5, 11. Combined profit is 16, 16, 19, 17. The range falls from 10 and 8 to 3. Benefits: stable profit and access to new markets. Costs: few cost synergies and weaker management focus.

The price of a takeover

A target’s shares are £2.50 each and there are 40m shares: market value £100m. A 30% premium gives £3.25 a share, or £130m. The extra £30m is recovered from £5m annual savings in six years, before any integration costs. Evaluate: gains depend on whether savings are real, how well staff and systems combine, and how much was borrowed.

Common errors

• Writing that profit is maximised where MR = MC without saying that MC must cut MR from below.
• Treating a short-run loss as a reason to shut down when revenue exceeds variable cost.
• Confusing a merger with organic growth, or horizontal with vertical integration.
• Listing objectives without linking each to price, output or profit.
• Calling every large firm profit-maximising without considering the divorce of ownership from control.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), version 1.2, section 3.3.1.3 and 3.3.1.4. First teaching September 2020, first AS exams May/June 2021, first A-level exams May/June 2022. Published by OxfordAQA.