Chapter Six Profit Maximization: Seeking Competitive Advantage

Copyright © Houghton Mifflin Company.All rights reserved. 6–26–2 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 Quantity 1 Quantity 2 If this is demand, what does total revenue look like?

Price Total Revenue Q Q Total Revenue and Demand elastic inelastic unit elastic

Copyright © Houghton Mifflin Company.All rights reserved. 6–56–5 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 SRATC Price 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 Q1Q2

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

Copyright © Houghton Mifflin Company.All rights reserved. 6–10 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

Copyright © Houghton Mifflin Company.All rights reserved. 6–15 Profit and Entry Economic profit or value added is the: excess of revenue over costs.

Copyright © Houghton Mifflin Company.All rights reserved. 6–16 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–17 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–18 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).

Copyright © Houghton Mifflin Company.All rights reserved. 6–19 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–20 Profit and Entry Entry means that the positive economic profit will be driven down to “normal.”

Copyright © Houghton Mifflin Company.All rights reserved. 6–21 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–22 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–23 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

Copyright © Houghton Mifflin Company.All rights reserved. 6–26 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–27 Sustaining Profit Economic profit arises from a distinctive capability--something unique and something inimitable.

Copyright © Houghton Mifflin Company.All rights reserved. 6–28 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–29 Sustaining Profit How can one sustain above normal (positive economic) profit? By barring entry! How is this done?

Copyright © Houghton Mifflin Company.All rights reserved. 6–30 Sustaining Profit Product differentiation 1.Reputation 2.Brand name

Copyright © Houghton Mifflin Company.All rights reserved. 6–31 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?

Copyright © Houghton Mifflin Company.All rights reserved. 6–32 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

Copyright © Houghton Mifflin Company.All rights reserved. 6–33 Summary of Selling Environments MarketNo. of Firms ProductEntry Perfect Competition manyidenticaleasy Monopoly one none Monopolistic Competition manydifferentiatedeasy Oligopoly fewSame or differentiated difficult

Copyright © Houghton Mifflin Company.All rights reserved. 6–34 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.

Copyright © Houghton Mifflin Company.All rights reserved. 6–35 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

Copyright © Houghton Mifflin Company.All rights reserved. 6–37 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 Individual Firm’s Demand Quantity MarketOne Firm

Copyright © Houghton Mifflin Company.All rights reserved. 6–41 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

Price Quantity Demand = MR MC Where is total cost? ATC Total Cost We need the average cost to know. Profit

Copyright © Houghton Mifflin Company.All rights reserved. 6–46 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 Individual Firm’s Demand 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 Revenue Total Cost Zero Economic Profit Demand falls Quantity Produced Declines

Copyright © Houghton Mifflin Company.All rights reserved. 6–50 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 PmPm QmQm

Price Quantity DEMAND SRATC MC MR What Q and what P maximize profit?

Copyright © Houghton Mifflin Company.All rights reserved. Monopoly With no entry by other firms, the economic profit is not competed away.

Copyright © Houghton Mifflin Company.All rights reserved. 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 MC ATC D MR Profit

Price Quantity MC ATC MR D As entry occurs, demand is taken away and the demand curve shifts inward. D2D2 MR 2 Profit

Copyright © Houghton Mifflin Company.All rights reserved. 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.

Copyright © Houghton Mifflin Company.All rights reserved. Oligopoly There are few firms. The product is differentiated or the same (compare autos vs. steel). Entry is difficult.