Readers Question: Is it better to sell more services/products with less profit, than sell less with high profits? What are the pros and cons to the employer, worker, and customer? i.e. high revenue low profit, vs low revenue high profit?
Classical economic theory suggests firms will seek to maximise profits. The benefits of maximising profit include:
- Profit can be used to pay higher wages to owners and workers. (though if a firm has monopsony power, the profit may not be shared equally amongst workers)
- Profit can be used to invest in research & development. This investment can potentially benefit the consumer. For example, without large profits, drug companies would have less ability to develop new drugs. High profit is often a justification for pharmaceuticals to have a degree of monopoly power (e.g. patents) because ultimately it is essential for creating the incentive to develop new treatments. However, this argument about research & development may depend on the industry. For example, it is now clear how much supernormal profit supermarkets need to be able to invest in research & development.
- Profit enables the firm to build up savings, which could help the firm survive an economic downturn. For example, in a recession, a firm could see a temporary loss, but if the firm has a reasonable level of savings and a history of profitability, the bank will be more willing to keep lending. However, profitable firms don’t necessarily save this profit for an economic downturn. Profit is often paid to shareholders in the form of dividends or used to finance expansion, such as mergers or takeovers. For example, commercial banks were very profitable in the boom years, leading up to 2007. But, when the credit crunch hit, they had very few resources to ride out the financial crisis.
- For firms listed on the stock market, high levels of profit will make the firm less susceptible to takeovers. If profit is low, shareholders may be disappointed in the low level of dividends and willing to sell to a takeover bid. You could argue this incentive to be profitable is good for consumers because the firm has incentives to be efficient and cut costs, which can lead to lower prices for consumers. However, you could argue, that the pursuit of short-term profit has drawbacks because the firm may not invest sufficiently in the long-term development of products and services. For example, train operating companies listed on the stock market may go for short-term profit, and ignore long-term investment for the industry.
Benefits of Pursuing Revenue Maximisation
Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.
- Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being the cheapest supermarket can help attract customers.
- Put competitors out of business. Pursuing sales maximisation may enable large firms to push rivals out of business. For example, a large supermarket with economies of scale could sell goods so cheaply; smaller rival firms can’t compete and go out of business. This enables the firm to have more market share and profit in the long term. Consumers could benefit from lower prices in the short-term, but if firms do go out of business, then they will have lower choice and face the prospect of less competition in the long-run.
- Economies of scale. Lower prices and higher sales can help firms with high fixed costs gain economies of scale (lower average costs). This could lead to lower prices for consumers.
- Pursuing revenue maximisation may be a clever way to increase long-term profitability. By gaining market share, firms enable economies of scale, greater sales and more market share. Therefore, in future, they will have greater ability to increase prices.
- However, in theory, consumers are protected from firms which seek to pursue ‘unfair competition,’ i.e. selling below cost. Firms are not allowed to pursue ‘predatory pricing’ – which is the deliberate setting of prices below cost to force rivals out of business. The OFT investigated supermarkets because they were concerned about the growth of monopoly power. However, apart from some minor cases, like price fixing in cheese, the supermarkets were largely cleared by the OFT. OFT probe shelved
- Greater influence. Some firms are not motivated by profit, but by exposure and influence in society. For example in the newspaper market, the newspaper may have a political agenda to promote. They may be happy to accept more political influence (due to cheap newspapers) rather than higher profit.
By pursuing sales maximisation, the firm may have more incentive to cut costs leading to lower wages for workers, but on the other hand, expansion could create new jobs.
Diagram of the difference between profit maximisation and Revenue maximisation
- Profit maximisation occurs at Q1, P1 (where MR=MC)
- Revenue maximisation will be at Q2, P2 (MR = 0)
- Sales maximisation (whilst making normal profit) will be Q4, P4.
It depends on the industry in question. For some industries, profit maximisation is necessary to finance investment and development. In other industries, pursuing short-term profit maximisation may lead to a big loss of market share and harm the firms prospects in the long run. For consumers, they should benefit if firms cut prices to increase sales. However, if price cuts are so large that other firms are forced out of business, this could harm them in the long run. Also, a degree of profit may help consumers if the firm uses it to improve the quality of the product. But, there is no guarantee that profit is used for re-investment.