What do Firms want to achieve? The sobering story of the overly successful Pret a Manger
In much of microeconomics we assume economic actors are seeking to maximise something. A consumer is assumed to be seeking to maximise their utility from consumption; a worker their net benefits from different occupations; an investor, their expected future returns from an investment. What do firms seek to maximise? The usual assumption is that firms wish to maximise their profits, and in the short-run this leads us to the familiar rule that a Profit Maximising firm will want to produce at the output where MC=MR. In the diagram below for a firm operating in non-perfect competition with a downward sloping demand (Average Revenue) curve for their product, the profit maximising output, where MC=MR, is 7, with a price of 80.
This firm’s Average Revenue at output 7 is 80, and given that output is 7 their Total Revenue is 80 x 7 = 560. Average Costs at 7 are 34.3, yielding a Total Cost of production of 240. So the firm’s Super Normal Profit is 560–240 = 320.
However in 1959 the economist William Baumol questioned whether firms really did want to maximise profits. He recognised that while most share-holders may wish to maximise the profits of the company, the day-to-day decisions regarding output and price were made by managers, and managers might wish to grow the firm’s revenue rather than its profit. In other words, managerial utility would be best served by pursuing the growing size of firm measured by turn-over. There are three reasons why managers may seek to maximise sales:
1. Larger sales give managers satisfaction and prestige and seem to indicate a successful business.
2. A growth in sales might allow the firm to exploit economies of scale.
3. Managers salaries are more often related to sales performance rather than profits.
Let us look at the effect of a firm seeking to Maximise its Revenue. In the above diagram a firm will maximise revenue at the output 12, where MR is zero. For any output less than this the firm can increase its Total Revenue by producing more. For any output beyond 12 Total Revenue will fall for additional output since Marginal Revenue will be negative. So the Revenue Maximising firm will produce at output 12 and sell at price 55. The Total Revenue of the firm is now 55 x 12 = 660, an advance on its previous Total Revenue at output 7 when total revenue was 560.
In terms of the objectives of the Managers this is a clear gain. The firm is selling more product and the money coming into the firm is as high as it can be. Managers and employees will have much to be pleased with. This seems to have been the strategy of Pret a Manger over the last few years. Numbers of shop outlets continually increased, consumption of drinks and foodstuffs was rising, employment of managers and workers increasing. However, post covid, the city centre stores (of which there were many) were unlikely to return to high sales for many years. In response to post covid pressures, Prets introduced a subscription based drinks option — something usually associated with Netflix or Spotify. We wrote about it here.
There is no doubt that, in terms of volumes, Pret a Manger’s initiative was a great success:
- In 2021, the subscription was used more than 667,000 times per week.
- Subscribers typically spend four times as much than non-subscribers
- Half year revenue for 2022 was up 230% (£357.8m) compared to the same period in 2021 (£155.4m)
The managers of Prets seem to have forgotten a problem created by the Revenue Maximisation model: the increase in revenue takes place at the expense of a reduction in profits! Baumol recognised this in his original model. He said that managers would seek to increase revenue subject to the need to generate enough profit to keep the shareholders happy. In our diagram, any increase in output beyond output 7 sees Marginal Costs exceeding Marginal Revenue. Any extra unit produced beyond 7 reduces profits, adding more to costs than it does to firm income. So beyond output 7 profits start to fall. The last output at which the firm can break even is output 11 where Average Revenue = Average Cost and only Normal Profits are made. If the firm produces at the Revenue Maximising output 12 it will make a LOSS equal to 200 since Average Revenue is now BELOW Average Costs.
The point at which profits are replaced by losses will depend partly on how fast costs rise as the firm increases output. And this seems to be the particular mistake Prets made with its loyalty scheme. They didn’t realise quite how fast costs would rise especially for fruit drinks and smoothies. The Marginal Cost of these products rises faster than for coffee, especially because of the labour time it requires to make them. So as their loyal customers were ordering lots of cold drinks as part of the loyalty scheme Marginal Costs rose quickly and soon the firm was making a LOSS on the scheme overall. Put simply, Prets raised their output too far, pushing up their costs and causing Total Costs to exceed Total Revenue. And this a problem since while a firm may wish to grow its revenue, unless it can cover its costs and make a profit to satisfy shareholders in the end it will go bankrupt and then stores will close and managers and workers will lose their jobs. This loss making yet successful scheme is brilliantly illustrated here.
In February 2023, Prets announced that smoothies and milkshakes would no longer be part of the subscription pack. This is an attempt to lower the Marginal and Average Cost curves sufficiently to restore profitability. Whether removing cold drinks from the deal will be sufficient to save the scheme overall is yet to be seen.
By KS & Dr I St John