1. Advanced Techniques for Profit Maximization
Chapter 14
Advanced Techniques for Profit Maximization

2. Advanced Techniques for Profit Maximization
Multiplant firms
Cost-plus pricing
Multiple markets
Price discrimination
Multiple products
Strategic entry deterrence

3. Multiple Plants If a firm produces in 2 plants, A & B
Allocate production so MCA = MCB
Optimal total output is that for which MR = MCT
For profit-maximization, allocate total output so that
MR = MCT = MCA = MCB

4. A Multiplant Firm (Figure 14.1)

5. Cost-Plus Pricing
Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization
Price charged represents a markup (margin) over average cost:
P = (1 + m)ATC
Where m is the markup on unit cost

6. Cost-Plus Pricing Does not usually produce profit-maximizing price
Fails to incorporate information on demand & marginal revenue
Uses average, not marginal, cost

7. Practical Problems with Cost-Plus Pricing (Figure 14.3)

8. Cost-Plus Pricing (Constant Costs)
Yields profit-maximizing price when optimal markup, m*, is applied to AVC:
P = (1 + m*)AVC
And optimal markup is chosen according to the following relation:
Where E* is price elasticity at profit-maximizing point of firm’s demand

9. Cost-Plus Pricing (Constant Costs)
When demand is linear & costs are constant (SMC = AVC), profit-maximizing value for E* is:
Where A is price-intercept of linear demand curve & AVC is constant

10. Multiple Markets If a firm sells in two markets, 1 & 2
Allocate output (sales) so MR1 = MR2
Optimal total output is that for which MRT = MC
For profit-maximization, allocate sales of total output so that
MRT = MC = MR1 = MR2

11. Price Discrimination
Method in which firms charge different groups of customers different prices for the same good or service

12. Deriving Total Marginal Revenue (Figure 14.4)

13. Profit-Maximization with Two Markets (Figure 14.5)

14. Multiple Products Related in consumption MRX = MCX and MRY = MCY
For two products, X & Y, produce & sell levels of output for which
MRX = MCX and MRY = MCY
MRX is a function not only of QX but also of QY (as is MRY) -- conditions must be satisfied simultaneously

15. Multiple Products Related in production as substitutes MRPX = MRPY
For two products, X & Y, allocate production facility so that
MRPX = MRPY
Optimal level of facility usage in the long run is where MRPT = MC
For profit-maximization:
MRPT = MC = MRPX = MRPY

16. Multiple Products Related in production as complements MRJ = MC
To maximize profit, set joint marginal revenue equal to marginal cost:
MRJ = MC
If profit-maximizing level of joint production exceeds output where MRJ kinks, units beyond zero MR are disposed of rather than sold
Profit-maximizing prices are found using demand functions for the two goods

17. Profit-Maximizing Allocation of Production Facilities (Figure 14.7)

18. Profit-Maximization with Joint Products (Figure 14.9)

19. Strategic Entry Deterrence
Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a market
Two types of strategic moves
Limit pricing
Capacity expansion

20. Limit Pricing
Established firm(s) commits to setting price below profit-maximizing level to prevent entry
Under certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever

21. Limit Pricing: Entry Deterred (Figure 14.11)

22. Limit Pricing: Entry Occurs (Figure 14.12)

23. Capacity Expansion
Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacity
When increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of production
Requires established firm to cut its price to sell extra output

24. Excess Capacity Barrier to Entry (Figure 14.13)

25. Excess Capacity Barrier to Entry (Figure 14.13)