The term ‘low profit’ is a subjective term and is dependent on the type of industry and structure of the
market. Economic theory suggests normal profits, occurring when firms make £0 is low profit and that
anything above is supernormal profit. Classical economic theory also suggests that all firms are profit
maximisers which occurs where MC = MR, meaning a firms’ profits are greatest when the addition to
sales revenue received from the last unit of output equals the addition to total cost incurred from the
production of the last unit of input. This is a universal condition whatever the market structure. A firm
seeking profit maximisation must be efficiently managed as they cut unnecessary costs and exploit their
market by either using economies of scale or through non-price competition. A way in which a firm may
differ from this may be through the impacts of the divorce of ownership from control and the principal
agent problem.
The divorce of ownership from control is particularly evident in concentrated markets and especially
monopolies. Monopolies are markets where one firm has complete market power and are price makers.
A monopoly firm wanting to achieve profit maximisation will choose to produce where MC = MR, as
shown in figure 1 and produce at profit maximising quantity Q1 to make supernormal profits P1ABC1.
However, although this monopoly firm is making supernormal profits, they may still be making a loss due
to the divorce of ownership from control which can encourage diseconomies of scale and X-inefficiencies.
Therefore, although the monopoly firm is not producing at normal profits, they may still be inefficiently
managed. X-inefficiencies may arise from having too many managers (known as agents), where
coordination within the firm is difficult. Additionally, monopolies tend to have many shareholders (known
as principals) who may have conflicting objectives. To them, profit maximisation is the most important
objective, and if successfully carried out, the firm would achieve efficient management. However,
managers may be incentivised to achieve other objectives. For example, if pay is purely based on sales,
sales revenue maximisation may be achieved instead, thus becoming inefficiently managed as profit
maximising quantities are not being produced. This principal agent problem is fuelled through
asymmetric information as a result of agents knowing more than the principal where the principal cannot
enforce these objectives as they are not as knowledgeable. Therefore, although monopolies aren’t
making low profits, they may be inefficiently managed due to the mismatch of objectives between
managers and the shareholders who own the firm.
On the other hand, small firms are usually owned and managed by an entrepreneur. An entrepreneur is a
decision maker and financial risk taker who decides on standard economic questions like what and how
much to produce. If both management and ownership lie in one individual, the firm is less likely to suffer
from divorce of ownership from control. Small firms are likely to exist within contestable markets with
low barriers to entry and at high risk from hit and run competition. Perfectly competitive markets, for
example, make normal profits in their long run position, thus making £0 profits. Referring to the question,
this low profit must indicate the firms are inefficiently managed. However, this may not be the case.
Many small firms struggle against competitive pressures from rivals and new entrants and are therefore
forced to become the most efficient firm to reduce costs and beat rival competitors. In this case, the
objective of survival and profit maximisation may be the most important. These objectives can be
enforced by the entrepreneur, shown in figure 2, where in order to survive a competitive market, the firm
must produce at Q1. Additionally, perfectly competitive firms are unlikely to be subject to the satisficing
principle where management tries to resolve conflict between different interest groups by only satisficing
profit and maximising their own managerial incentives. For highly competitive markets, firms who are
content with satisfactory profits and a degree of inefficiency may be forced out by new entrants who are
more competitive. Therefore, although in perfectly competitive markets, firms only make normal profits,
this doesn’t necessarily indicate they are inefficiently managed and is instead, a feature of the market
structure itself.
Natural monopolies may also be subject to inefficiencies despite the market allowing for supernormal
profits. This is particularly evident in the utility industries like water which require large sunk costs and
large investments in infrastructure. Therefore, to justify this expense, high prices must be charged, and
consumers must be exploited. However, since water is an essential commodity, the government must
regulate these industries through regulatory bodies like OFWAT. These bodies regulate prices and
market. Economic theory suggests normal profits, occurring when firms make £0 is low profit and that
anything above is supernormal profit. Classical economic theory also suggests that all firms are profit
maximisers which occurs where MC = MR, meaning a firms’ profits are greatest when the addition to
sales revenue received from the last unit of output equals the addition to total cost incurred from the
production of the last unit of input. This is a universal condition whatever the market structure. A firm
seeking profit maximisation must be efficiently managed as they cut unnecessary costs and exploit their
market by either using economies of scale or through non-price competition. A way in which a firm may
differ from this may be through the impacts of the divorce of ownership from control and the principal
agent problem.
The divorce of ownership from control is particularly evident in concentrated markets and especially
monopolies. Monopolies are markets where one firm has complete market power and are price makers.
A monopoly firm wanting to achieve profit maximisation will choose to produce where MC = MR, as
shown in figure 1 and produce at profit maximising quantity Q1 to make supernormal profits P1ABC1.
However, although this monopoly firm is making supernormal profits, they may still be making a loss due
to the divorce of ownership from control which can encourage diseconomies of scale and X-inefficiencies.
Therefore, although the monopoly firm is not producing at normal profits, they may still be inefficiently
managed. X-inefficiencies may arise from having too many managers (known as agents), where
coordination within the firm is difficult. Additionally, monopolies tend to have many shareholders (known
as principals) who may have conflicting objectives. To them, profit maximisation is the most important
objective, and if successfully carried out, the firm would achieve efficient management. However,
managers may be incentivised to achieve other objectives. For example, if pay is purely based on sales,
sales revenue maximisation may be achieved instead, thus becoming inefficiently managed as profit
maximising quantities are not being produced. This principal agent problem is fuelled through
asymmetric information as a result of agents knowing more than the principal where the principal cannot
enforce these objectives as they are not as knowledgeable. Therefore, although monopolies aren’t
making low profits, they may be inefficiently managed due to the mismatch of objectives between
managers and the shareholders who own the firm.
On the other hand, small firms are usually owned and managed by an entrepreneur. An entrepreneur is a
decision maker and financial risk taker who decides on standard economic questions like what and how
much to produce. If both management and ownership lie in one individual, the firm is less likely to suffer
from divorce of ownership from control. Small firms are likely to exist within contestable markets with
low barriers to entry and at high risk from hit and run competition. Perfectly competitive markets, for
example, make normal profits in their long run position, thus making £0 profits. Referring to the question,
this low profit must indicate the firms are inefficiently managed. However, this may not be the case.
Many small firms struggle against competitive pressures from rivals and new entrants and are therefore
forced to become the most efficient firm to reduce costs and beat rival competitors. In this case, the
objective of survival and profit maximisation may be the most important. These objectives can be
enforced by the entrepreneur, shown in figure 2, where in order to survive a competitive market, the firm
must produce at Q1. Additionally, perfectly competitive firms are unlikely to be subject to the satisficing
principle where management tries to resolve conflict between different interest groups by only satisficing
profit and maximising their own managerial incentives. For highly competitive markets, firms who are
content with satisfactory profits and a degree of inefficiency may be forced out by new entrants who are
more competitive. Therefore, although in perfectly competitive markets, firms only make normal profits,
this doesn’t necessarily indicate they are inefficiently managed and is instead, a feature of the market
structure itself.
Natural monopolies may also be subject to inefficiencies despite the market allowing for supernormal
profits. This is particularly evident in the utility industries like water which require large sunk costs and
large investments in infrastructure. Therefore, to justify this expense, high prices must be charged, and
consumers must be exploited. However, since water is an essential commodity, the government must
regulate these industries through regulatory bodies like OFWAT. These bodies regulate prices and
