Behavioural Theories of the Firm (Behavioural Economics)

As a response to the question from Yousuf last week, here is the simplest explanation (and all you need to know) on why firms organisational decision making.

Behavioural theories of the firm consider alternatives to profit maximisation as a business objective. 

Behavioural economists believe that large businesses are complex organisations made up of many different stakeholders.

Stakeholders are groups made up of people who each have a vested interest in the activity of a business. Examples include:

• Managers employed by a business and other employees
• Shareholders are people who have a stake in a business
• Customers
• The government and its agencies

Each group of stakeholders will have different objectives or goals. 

The dominant group at any moment can focus on their own objectives. For example price and output decisions may be taken at a local level by managers, with shareholders taking only a distant view of the company's performance and strategy.

Examples of alternatives to profit maximisation

Satisficing behaviour 

This happens when businesses aim for minimum acceptable levels of achievement in terms of revenue and profit.

Read more on satisficing behaviour

Sales (output) maximisation

Selling as much as you can without making a loss. At sales maximisation there are normal profits or no supernormal profits.

Sales (revenue) maximisation

The objective of maximising sales revenue rather than profits was developed by economist William Baumol whose work focused on the behaviour of manager-controlled businesses.

• Annual salaries and perks are linked to sales revenue rather than profits
• Companies geared towards maximising revenue are likely to make frequent use of price discrimination to extract extra revenue and marginal profit from consumers
• A business might also aim to maximise sales revenue rather than profits because it wishes to deter the entry of new firms
• If a firm decides to aim to maximise sales revenue rather than profits, one of the consequences might be a reduction in the price of the firm's shares since the rate of profit is likely to be lower

Read more about sales maximisation as a business objective

Managerial Satisfaction Model

If a firm's managers are looking to maximise revenue rather than profit, this will lead to a different price and output combination.

Assuming that the firm's costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective.

Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised.

Non-Price competition & why it is important for oligopolies

Non-price competition involves advertising and marketing strategies to increase consumer demand and develop brand loyalty.

Businesses will use other policies to increase market share:

• Better quality of customer service including guaranteed delivery times for consumers and low-cost servicing agreements, good after-sales service
• Longer opening hours for retailers, 24 hour online customer support.
• Discounts on product upgrades when they become available in the market.
• Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, Apple has signed exclusive distribution agreements with T-Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements give Apple 10 percent of sales from phone calls and data transfers made over the devices

Brands and Non Price Competition Brands provide clarity and guidance for choices made by companies, consumers, investors and other stakeholders. They embody a core promise of values and benefits consistently delivered and provide the signposts needed to make decisions

BOGOF techniques – buy one, get one free tactics

1. Loyalty cards, free delivery, online ordering, free gifts, guarantees
2. Location of stores and outlets and also the types of outlets that they operate e.g. local convenience compared to hypermarkets

Advertising spending runs in millions of pounds for many firms. Some businesses apply a profit maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal revenue from extra sales exceeds the marginal cost of the campaign and supplying an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a campaign.

Other businesses see advertising as a way of increasing revenue. If persuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the consumer surplus that a business might extract.

High spending on marketing is important for new business start-ups and for firms trying to break into an existing market where there is consumer or brand loyalty to the existing products in

Brand loyalty

• A brand name is a name used to distinguish one product from its competitors

• It can apply to a single product, an entire product range, or even a company (e.g. Virgin, Ferrari, Bang and Olufsen)

• Brand loyalty is hugely important. The costs of acquiring a new customer vastly outweigh the expense of selling more to existing buyers

• When brand loyalty is strong, cross-price elasticity of demand for price changes between two substitutes weakens and fewer consumers will switch their demand when there is a change in relative prices in the market.

• Robust brand loyalty makes it easier to charge premium prices and earn supernormal profits because loyalty is a barrier to entry.

• When we become strongly attached to a brand, our purchasing decisions are more likely to stay in default mode and we may no longer even consider rival products.

Competitiveness – a key to success in an oligopoly

Traditionally, the main measures of competitiveness are in financial or marketing terms. For example, a competitive business might be expected to achieve one or more of the following:

• A higher growth rate (sales, revenues) than competitors and the market as a whole
• Higher-than average net profit margin (compared with others in the same industry)
• Better than average returns on investment – again, compared with competitors
• A high (perhaps leading) market share – measured in either value or volume terms. The leading firms in a market usually enjoy a significant proportion of the available revenues or customer demand, unless the market is highly fragmented.
• The strongest brand reputation in the market – e.g. brand awareness
• A clearly defined unique selling point ("USP") that enables the business to differentiate its product or service in the eyes of customers
• Significant access to, or control of, distribution channels in the market (e.g. products or brands that are widely stocked or demanded by intermediaries who provide distribution to the final consumers)
• Better product quality – e.g. reliability, product features, performance
• Better customer service – e.g. after-sales support, customer information, handling of problems & complaints
• Better than average efficiency – e.g. being able to produce at a lower unit cost than most other competitors, either though better productivity or economies of scale

IF SUCCESSFUL, HOW WILL NON-PRICE STRATEGIES AFFECT THE IMPERFECTLY COMPETITIVE MARKET DIAGRAM??