ECONOMICS HL TEST

Albert Kwasi Adu Boahen

DP1C

(a)Explain why in perfect competition abnormal profits are only made in the short run.[10]

(b) Using real-world examples, evaluate the view that firms will always seek to maximize their profits.
[15]

A.

The perfect competition is a market structure entailing that it refers to the organizational
characteristics of a market, including the degree and nature of competition for goods and
services, a market structure looks at the correlation between sellers and other sellers, sellers to
buyers. In the case of the perfect competition market structure it can be characterized by
numerous firms producing homogeneous products which are goods and services that are
identical to each other in the market and consumers also view the goods or services to be
identical to each other. Free entry is when new firms can freely enter the perfectly competitive
market by the establishment of production and commencing the sale of the product, and they
can exit freely as there are low barriers to exit, allowing the firms to leave the market freely. In a
perfectly competitive market, firms attain abnormal profit in the short run. This is when the firm's
total revenue is greater than total costs. Total revenue is the company's total income from selling
goods and services, total cost on the other hand is the sum of all costs taken by a firm to
produce a specific level output of a good or service. Total cost includes both implicit and explicit
costs incurred by the firm in producing its output, explicit costs being the direct expenses made
by the firm like wages and rent, while implicit costs are the opportunity costs of using resources
already possessed, the opportunity cost is anything else they could have been used for. This
essay will look at what causes abnormal profits in the perfectly competitive market to be limited
to the short run.

In the perfectly competitive market structure firms are price takers, price takers are defined as
firms that cannot influence the market price. This feature of the perfectly competitive market is
crucial because this limits firms to the single choice of adjusting the quantity they produce to
maximize profit. In the short run, a perfectly competitive market earns abnormal profits due to
sudden increases in demand, momentary shortages in supply, or technological advantages for
capable firms. The key term “ short run" refers to a time where at least one input for example
capital is fixed, and other factors of production like labour and raw materials are varied. In the
context of firms making abnormal profit meaning firms are attaining profits above the normal
level in the short run, this abnormal profit is hard to maintain due to market forces that will bring
profits back to the normal level at total revenue is equal total cost. Take into consideration the
agricultural market and goods like rice crops. Harsh weather could destroy several supplies of
rice crops. This will cause wheat prices to skyrocket due to the short term scarcity, this will
cause farmers who still managed to have a good harvest despite the disaster to enjoy abnormal
profits due to the increased price, till other farmers are able to produce again leading to normal
profits where total revenue is equal to total cost.

Abnormal profits serve as a strong signal to new entrants into a market, as the general aim of
firms is to maximise profits aside from alternate business objectives which are other aims firms
may have aside from profit maximisation. New firms are attracted to these higher than normal
returns, existing firms are also encouraged to expand production to increase revenue. This is
where the assumption that the perfectly competitive market has no barriers to entry. The new
entrants will increase overall market supply. A real life example of this being Uber launched in
2009. Uber is a ride sharing company allowing people to take cheap rides through their phones
across the country. The company had a first mover advantage over other firms as they were the
first to introduce the service, making for low competition and high demand.

The supply curve is shifted to the right as market supply increases, this increase in supply
causes market price to fall, shrinking the abnormal profits the firm was earning, this continues till
the fall till the market price equals the average total cost of production for firms, where firms
are earning normal profits covering all costs but earn no economic profit.

In the crypto mining sector, when the price of bitcoin was skyrocketing, miners who
authenticated transactions and added onto the blockchain, received great rewards in the form of
abnormal profit. This attracted new miners into the cryptocurrency mining market, increasing the
network's computing power. As more miners joined, mining became more difficult, and the new
miners caused the rewards to be distributed across a larger pool, driving down the profit earned
by individual miners till they earn only normal profits.
Diagram 1: supernormal profit earned by Diagram 2: The firms make normal profit in the
Firms in the short run in the perfect long run
competition

The move from abnormal profits in the short run to normal profits in the short run can be
illustrated diagramatically. Initially firms in a perfectly competitive market might face a price
above the average total cost (ATC) curve, leading to an output level at which marginal cost(MC)
equals price(P), and producing an abnormal profit represented by the area(P - ATC) multiplied
by the quantity produced. As new firms enter the market, market supply shifts to the right,
causing market price to fall. The demand curve of the individual firms(which is perfectly elastic
as the market price) shifts downward until it is tangent to the ATC curve at the minimum point.
At this point, P = ATC, and the firm earns only normal profits. Firm are allocatively efficient as
they produce were (MC) equals (P), which is equal to marginal benefit.

To conclude, the dynamic nature of perfect competition makes sure that abnormal profits are
temporary, existing only in the short run. New firms are attracted to the profitability of the good
or service, increasing market supply, but reducing profits benefiting consumers till firms start
making normal profit . The Perfectly competitive market drivin by its absence of barriers to entry
and the pursuit of economic profit. underscores the productivity of impeccably competitive
markets in distributing assets and dispensing with overabundance productivity. The examples
of agricultural markets, uber, and cryptocurrency mining serve to show how these
theoretical principles apply to the real world, highlighting the forces that shape
competitive market outcomes.

B.
Using real-world examples, evaluate the view that firms will always seek to maximize their profits.
[15]

Profit maximization is the assumption in economic theory, that firms are expected to
operate rationally by equating marginal revenue (MR) with marginal cost (MC) to
achieve the highest possible profit. This occurs when the difference between total
revenue (TR) and total cost (TC) is maximized. However, in practice, firms may pursue
alternative objectives due to various constraints and motivations. This essay looks at
the validity of the view that firms always seek to maximize their profits, utilizing
real-world examples and economic reasoning.

In perfectly competitive markets for example, profit maximization is crucial for survival
because firms come into pressure from competitors and price-taking behavior. For
example, manufacturing firms like Toyota optimize production efficiency through
manufacturing techniques to minimize costs while maximizing output. Apple Inc.
exemplifies profit maximization through its premium pricing strategy and economies of
scale, allowing it to maintain high profit margins while meeting consumer demand.

Several challenges arise in profit maximisation that block firms from always pursuing
this goal. Firms might prioritize objectives other than profit maximization being
alternate business objectives, such as corporate social responsibility (CSR), market
share growth, or employee satisfaction. For instance: Patagonia, an outdoor apparel
company, places environmental sustainability at the core of its business model. It
invests heavily in eco-friendly materials and donates 1% of sales to environmental
causes, even at the expense of higher costs or even Ben & Jerry’s integrates social
justice initiatives into its operations, demonstrating a commitment to ethical
considerations over short-term profitability. These strategies may enhance long-term
profitability by fostering brand loyalty and goodwill but deviate from traditional
short-term profit-maximizing behavior.

Managers in firms in which control and ownership are divided (i.e., firms that are
publicly owned) will favor "profit satisfaction" over profit maximization. In other words,
when managers find an acceptable profit over the best possible profit for more reasons
due to conflicting incentives of executives and shareholders—a process known as the
principal-agent problem.

Market conditions likewise determine firm behavior. In very competitive markets or in

industries having high barriers to entry (for example, new technology start-ups),
companies occasionally produce at loss in order to achieve market space or achieve
long-term growth ambition. For example: Uber and Amazon firms set out aggressive
market penetration tactics of selling at price levels below the cost or offer free services
in initial stages forgoing short-run profitability for later-day dominance.

The mention of "always" is significant as it implies a universality across all firms and
circumstances. While most firms will seek profit maximization due to competitive
forces and shareholder pressures, real-world limitations might lead them to seek
alternative objectives. Companies will tend to strictly adhere to the MR = MC concept in
perfectly competitive markets or in fields subject to intense investor scrutiny (i.e.,
production or SaaS). However, for those industries where branding, CSR, or stakeholder
satisfaction are crucial—such as the consumer-goods or co-op industries—other goals
may be prioritized.
This graph represents a monopoly or imperfect competition market structure where a
firm is earn supernormal profit. The firm maximizes profit at the quantity Q1, where
marginal cost (MC) equals marginal revenue (MR). The corresponding price is P1,
determined from the average revenue (AR) curve. The firm's average cost (AC) is at C1,
which is lower than the price, resulting in supernormal profit (the shaded area between
P1 and C1). This demonstrates how firms with market power can set prices above
costs, leading to sustained abnormal profits in the short run. This is a firm operating
with the aim of profit maximising although not allocatively efficient. Society also suffers
a welfare loss.

In conclusion, while profit maximization is a fundamental theoretical concept in

economics, it is not necessarily practiced due to other business objectives, managerial
autonomy, and market forces. Firms balance a number of objectives based on their
missions and strategic imperatives. Therefore, the supposition that firms will always
seek to maximize their profits simplifies the complexity of real business behavior. Firms
are likely to pursue objectives that deviate from strict profit maximization but overlap
with long-term sustainability or ethical issues.

Bibliography

DealHub. (2024a). Profit Maximization. [online] Available at:

https://dealhub.io/glossary/profit-maximization/.
DealHub. (2024b). Profit Maximization. [online] Available at:
https://dealhub.io/glossary/profit-maximization/.