Chapter Six Profit Maximization: Seeking Competitive Advantage.
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Transcript of Chapter Six Profit Maximization: Seeking Competitive Advantage.
![Page 1: Chapter Six Profit Maximization: Seeking Competitive Advantage.](https://reader036.fdocuments.net/reader036/viewer/2022062802/56649ef25503460f94c0379c/html5/thumbnails/1.jpg)
Chapter Six
Profit Maximization: Seeking Competitive
Advantage
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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?
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Price 1
Price 2
Quantity1 Quantity2
If this is demand, what does total revenue look like?
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Price
TotalRevenue
Q
Q
Total Revenue and Demand
elastic
inelastic
unit elastic
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Copyright © Houghton Mifflin Company.All rights reserved. 6–5
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.
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DEMAND
SRATCPrice
Quantity
What is this area?
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Price
Quantity
MC
MR
What is happening in the cross hatched area?
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D
MC
MR
What is profit maximizing P and Q?
P1
P2
P3
Q1 Q2
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If there are many rivals and free entry, where is MR? What is profit maximizing P and Q?
P
Q
Demand
MC
MR
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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.
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D
MC
MR
What is profit?
P1
Q1
ATC
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D
MC
MR
What is profit? Total revenue -
P1
Q1
ATC
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D
MC
MR
What is profit? Total revenue -
P1
Q1
ATC
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D
MC
MR
What is profit? Total revenue - total cost
P1
Q1
ATC
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Copyright © Houghton Mifflin Company.All rights reserved. 6–15
Profit and Entry
• Economic profit or value added is the:
• excess of revenue over costs.
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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.
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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.
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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).
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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.
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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.”
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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.
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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.
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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.
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D
MC
MR
What is profit?
P1
Q1
ATC
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D
MC
MR
P1
Q1
ATC
Entry Changes Demand as One Firm Takes Market Share from Another
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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.
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Copyright © Houghton Mifflin Company.All rights reserved. 6–27
Sustaining Profit
• Economic profit arises from a distinctive capability--something unique and something inimitable.
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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.
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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?
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Copyright © Houghton Mifflin Company.All rights reserved. 6–30
Sustaining Profit
Product differentiation
1. Reputation
2. Brand name
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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?
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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
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Copyright © Houghton Mifflin Company.All rights reserved. 6–33
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
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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.
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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.
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Individual Firm’s Demand
Quantity
PRICE
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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?
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Price
Quantity
The market demand is the sum of every consumer’s demand; it would be the
standard-looking demand curve.
Market Demand
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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
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Price
Quantity
--------P
What does this mean for the individual firm?
Market Demand
Market Supply
Individual Firm’s Demand
Quantity
Market One Firm
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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?
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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.
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Price
Quantity
Demand
MC
What is the profit maximizing P and Q?
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Price
Quantity
Demand = MR
MC
Total Revenue
Total Revenue
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Price
Quantity
Demand = MR
MC
Where is total cost?
ATC
Total Cost
We need the average cost to know.
Profit
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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.
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Price
Quantity
--------P
What does this mean for the individual firm?
Market Demand
Market Supply
Individual Firm’s Demand
Quantity
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Price
Quantity
Demand = MR
MC ATC
Total Cost
Profit
The firm was earning a profit.
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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
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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.
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Copyright © Houghton Mifflin Company.All rights reserved.
Monopoly
• Consists of one producer (seller).
• There’s no entry.
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So, consider the monopoly:
MC
Demand
MR
Price
Quantity
Pm
Qm
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Price
Quantity
DEMAND
SRATCMC
MR
What Q and what P maximize profit?
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Copyright © Houghton Mifflin Company.All rights reserved.
Monopoly
• With no entry by other firms, the economic profit is not competed away.
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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.
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Price
Quantity
No Barriers but Differentiated Products
MCATC
DMR
Profit
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Price
Quantity
MCATC
MR D
As entry occurs, demand is taken away and the demand curve shifts inward.
D2MR2
Profit
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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.
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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.