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Chapter Six
Profit Maximization:
Seeking Competitive
Advantage
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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6–2
If this is demand, what does total revenue
look like?
Price 1
Price 2
Quantity1
Quantity2
Total Revenue and Demand
Price
elastic
unit elastic
inelastic
Total
Revenue
Q
Q
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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6–5
What is this area?
Price
SRATC
DEMAND
Quantity
What is happening in the cross
hatched area?
Price
MC
Quantity
MR
What is profit maximizing P and Q?
MC
P1
P2
P3
MR
Q1
D
Q2
If there are many rivals and free entry, where is
MR? What is profit maximizing P and Q?
MC
Demand
MR
P
Q
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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6–10
What is profit?
MC
ATC
P1
MR
Q1
D
What is profit?
Total revenue MC
ATC
P1
MR
Q1
D
What is profit?
Total revenue MC
ATC
P1
MR
Q1
D
What is profit?
Total revenue - total cost
MC
ATC
P1
MR
Q1
D
Profit and Entry
• Economic profit or value added is the:
• excess of revenue over costs.
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6–15
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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6–16
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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6–17
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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6–18
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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6–19
Profit and Entry
• Entry means that the positive economic
profit will be driven down to “normal.”
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6–20
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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6–21
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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6–22
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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6–23
What is profit?
MC
ATC
P1
MR
Q1
D
Entry Changes Demand as One Firm Takes
Market Share from Another
MC
ATC
P1
MR
Q1
D
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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6–26
Sustaining Profit
• Economic profit arises from a distinctive
capability--something unique and
something inimitable.
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6–27
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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6–28
Sustaining Profit
• How can one sustain above normal
(positive economic) profit?
• By barring entry!
• How is this done?
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6–29
Sustaining Profit
Product differentiation
1. Reputation
2. Brand name
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6–30
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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6–31
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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6–32
Summary of Selling Environments
Market
No. of
Firms
Product
Entry
Perfect
Competition
many
identical
easy
Monopoly
one
one
none
Monopolistic
Competition
many
differentiated
easy
Oligopoly
few
Same or
differentiated
difficult
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6–33
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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6–34
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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6–35
PRICE
Individual
Firm’s
Demand
Quantity
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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6–37
The market demand is the sum of every
consumer’s demand; it would be the
standard-looking demand curve.
Price
Market
Demand
Quantity
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.
S
Price
P --------
D
Quantity
What does this mean for the individual
firm?
Market
One Firm
Market
Supply
Price
Individual
Firm’s
Demand
P -------Market
Demand
Quantity
Quantity
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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6–41
With many rivals and free entry, where is MR?
What is the profit maximizing P and Q?
MC
Price
Demand
This is also MR and
average revenue.
Quantity
What is the profit maximizing P and Q?
MC
Price
Demand
Quantity
Total Revenue
MC
Price
Demand = MR
Total
Revenue
Quantity
Where is total cost?
We need the average cost to know.
MC
Price
ATC
Demand = MR
Profit
Total Cost
Quantity
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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6–46
What does this mean for the individual
firm?
Market
Supply
Price
Individual
Firm’s
Demand
P -------Market
Demand
Quantity
Quantity
The firm was earning a profit.
MC
Price
ATC
Demand = MR
Profit
Total Cost
Quantity
But with entry, the profit is competed away.
Zero Economic Profit
MC
Price
ATC
Demand = MR
Total
Total
Revenue
Cost
Quantity
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.
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6–50
Monopoly
• Consists of one producer (seller).
• There’s no entry.
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So, consider the monopoly:
Price
MC
Pm
Demand
Qm
Quantity
MR
What Q and what P maximize profit?
MC
Price
SRATC
DEMAND
Quantity
MR
Monopoly
• With no entry by other firms, the
economic profit is not competed away.
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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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No Barriers but Differentiated Products
Price
MC
ATC
Profit
D
MR
Quantity
As entry occurs, demand is taken away
and the demand curve shifts inward.
Price
MC
ATC
Profit
MR
MR2
Quantity
D2
D
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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Oligopoly
• There are few firms.
• The product is differentiated or the
same (compare autos vs. steel).
• Entry is difficult.
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