Chapter Six Profit Maximization: Seeking Competitive Advantage

Chapter Six

Profit Maximization: Seeking Competitive

Advantage

Copyright © Houghton Mifflin Company.All rights reserved. 6–2

How does a firm maximize profits?

• What decisions do the executives of a firm have to make?

• Consider a single product firm -- a firm that produces and sells only one product?

• Decisions:• What price to charge?

• How much to produce?

Price 1

Price 2

Quantity1 Quantity2

If this is demand, what does total revenue look like?

Price

TotalRevenue

Q

Q

Total Revenue and Demand

elastic

inelastic

unit elastic


Earning a Profit

• So, we have various demand curves facing a single firm, depending on the number of rivals, barriers, and type of product.

• We put the demand together with the cost to determine the profit.

DEMAND

SRATCPrice

Quantity

What is this area?

Price

Quantity

MC

MR

What is happening in the cross hatched area?

D

MC

MR

What is profit maximizing P and Q?

P1

P2

P3

Q1 Q2

If there are many rivals and free entry, where is MR? What is profit maximizing P and Q?

P

Q

Demand

MC

MR


Earning a Profit

• Let’s now determine the amount of profit at the price and quantity where profit is maximized:

• Profit is at a MAXIMUM where

• MR = MC.

• The amount of profit would be the total revenue less total costs.

D

MC

MR

What is profit?

P1

Q1

ATC

D

MC

MR

What is profit? Total revenue -

P1

Q1

ATC

D

MC

MR

What is profit? Total revenue -

P1

Q1

ATC

D

MC

MR

What is profit? Total revenue - total cost

P1

Q1

ATC


Profit and Entry

• Economic profit or value added is the:

• excess of revenue over costs.


Profit and Entry

• Positive economic profit means what?

• Revenues are sufficient to pay all costs including the opportunity costs of the investor’s (owner’s) capital.


Profit and Entry

• Owner’s (shareholders) could not do better investing in any other project.

• When other investors see the return, they too want to get in on the good thing.

• They invest in competing firms or try to buy into this firm.


Profit and Entry

• When they invest in new or competing firms, the supply of the product or service increases.

• When they invest in the profitable firm, it drives up the price on the ownership and lowers the rate of return (it increases K available to firm).


Profit and Entry

• These actions are referred to as entry.

• Entry: When investors (entrepreneurs) begin a new business or get involved with an existing one.


Profit and Entry

• Entry means that the positive economic profit will be driven down to “normal.”


Profit and Entry

• Negative economic profit means what?

• Revenues are not sufficient to pay all costs, including the opportunity costs of the investor’s (owner’s) capital.


Profit and Entry

• Owner’s (shareholders) then can do better investing in another project.

• Investors want to get in on a better deal and therefore invest in competing firms or or other projects.


Profit and Entry

• When they take their money out of the firm, the price on the ownership falls (it decreases K available to firm).

• In some cases firms exit the business and thus supply falls.

D

MC

MR

What is profit?

P1

Q1

ATC

D

MC

MR

P1

Q1

ATC

Entry Changes Demand as One Firm Takes Market Share from Another


Sustaining Profit

• Profit cannot be obtained on a sustained basis simply by doing the same thing other people do.

• Sustained competitive advantage is acquired through the ability to protect an innovation.


Sustaining Profit

• Economic profit arises from a distinctive capability--something unique and something inimitable.


Sustaining Profit

• Distinctive capability enables a firm to produce at lower cost than its competitors or to enhance the value of its products.

• A firm with no distinct capabilities may still be able to achieve a competitive advantage if it holds a strategic asset.


Sustaining Profit

• How can one sustain above normal (positive economic) profit?

• By barring entry!

• How is this done?


Sustaining Profit

Product differentiation

1. Reputation

2. Brand name


Sustaining Profit

• Suppose a firm creates a new or differentiated product but there are no barriers to entry.

• What will happen?

• Will it earn economic profit?

• For how long?


Sustaining Profit

• Whether a firm can sustain an economic profit depends on the selling environment in which it operates:

• Four MODELs of selling environments are discussed by economists:

• Perfect competition

• Monopoly

• Monopolistic competition

• Oligopoly


Summary of Selling Environments

Market No. of Firms

Product Entry

PerfectCompetition

many identical easy

Monopoly one one none

MonopolisticCompetition

many differentiated easy

Oligopoly few Same or differentiated

difficult


What is perfect competition?

It is a particular type of selling environment where

1. There are many, many small firms.

2. All firms produce the same product.

3. Entry and exit are easy.

4. Information is perfect.


What does the demand curve look like for a single firm?

• Because there are many rivals, easy entry, and all firms produce an identical product:

• Then demand for an individual firm is extremely elastic.

Individual Firm’s Demand

Quantity

PRICE


Where does this demand come from, and how is the price determined?

• It comes from the market.

• So, what does the market demand curve look like?

Price

Quantity

The market demand is the sum of every consumer’s demand; it would be the

standard-looking demand curve.

Market Demand

Market supply comes from adding up the quantities that ALL firms would be willing and

able to supply at each price. Remember, all firms are producing an identical product.

Price

Quantity

--------P

D

S

Price

Quantity

--------P

What does this mean for the individual firm?

Market Demand

Market Supply


Quantity

Market One Firm


What if an individual firm tries to change its price?

• What if single firm (one of 2 million in the market) raises its price?

• What would the single firm gain by lowering price?

With many rivals and free entry, where is MR? What is the profit maximizing P and Q?

Price

Quantity

Demand

MC

This is also MR and average revenue.

Price

Quantity

Demand

MC

What is the profit maximizing P and Q?

Price

Quantity

Demand = MR

MC

Total Revenue

Total Revenue

Price

Quantity

Demand = MR

MC

Where is total cost?

ATC

Total Cost

We need the average cost to know.

Profit


Keeping a Profit

• The firm makes a profit (above normal or positive economic profit).

• What then happens?

• Other firms want to get in on the good deal.

Price

Quantity

--------P

What does this mean for the individual firm?

Market Demand

Market Supply


Quantity

Price

Quantity

Demand = MR

MC ATC

Total Cost

Profit

The firm was earning a profit.

Price

Quantity

Demand = MR

MC ATC

But with entry, the profit is competed away.

Total RevenueTotal Cost

Zero Economic Profit

Demand falls

Quantity Produced Declines


Notice What This Says

• As long as there is free entry, a firm can not make ABOVE NORMAL profit.

• Competition will ensure the firm produces at the lowest possible cost in the most efficient manner.

Copyright © Houghton Mifflin Company.All rights reserved.

Monopoly

• Consists of one producer (seller).

• There’s no entry.

So, consider the monopoly:

MC

Demand

MR

Price

Quantity

Pm

Qm

Price

Quantity

DEMAND

SRATCMC

MR

What Q and what P maximize profit?


Monopoly

• With no entry by other firms, the economic profit is not competed away.


Monopolistic Competition

• Many producers (sellers).

• Each with a differentiated product.

• Easy entry; each entry is made with a slightly differentiated product.

• Since there is easy entry, economic profit will be competed away.

Price

Quantity

No Barriers but Differentiated Products

MCATC

DMR

Profit

Price

Quantity

MCATC

MR D

As entry occurs, demand is taken away and the demand curve shifts inward.

D2MR2

Profit


Monopolistic Competition

• Entry continues with other firms taking away market share and driving down the profits of the existing, above-normal profit firm--until there is zero economic profit.


Oligopoly

• There are few firms.

• The product is differentiated or the same (compare autos vs. steel).

• Entry is difficult.

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Chapter Six Profit Maximization: Seeking Competitive Advantage