Strategies to Maximize Profits
Efforts to maximize profits over time focus on increasing revenues and reducing the cost of doing business. The ability of a firm to increase revenues will depend either on the ability of the firm to increase the demand for their product (outward shift of the demand curve), or to realize greater revenues due to a change in the price of the product (this depends on the price elasticity of demand). Invariably, the market structure within which the firm competes will also greatly impact the ability of a firm to enhance its profits. On the other hand, efforts to reduce the average costs associated with producing a product depends on the ability of a firm to more effectively utilize its resources or to employ new technology to increase productivity.
All firms maximize their profits when they produce a level of output where the marginal revenue equals the marginal cost. The logic is as follows; as long as the marginal revenue exceeds the marginal cost then the additional revenue that results from producing the next unit of output will exceed the cost associated with producing the next unit of output. As a result, the firm will see its profits increase and it should produce more. It will then produce more, and continue to do so until the marginal revenue equals the marginal cost because every unit of output produced up to this point will lead to greater profits. With this definition established, the next step is to focus on each market structure.
In the case of firms that compete in the pure or perfect competition market structure, the problem of profit maximization is a very difficult one to solve. They are contrained to charging the market price and they participate in a market structure where firms are free to enter at will. Any profits lead to new entants and those profits will then disappear. As a result, these firms will focus primarily on cost control. They look to become more productive as a way to lower their average and marginal costs. The classic example of these firms would be that of farmers. Farmers are largely tied to market prices as they are determined in the commodity markets. You will therefore see them focus on cost management.
Monopolists face the market demand curve because they are the only firm providing the good or service in that market. As a result, on the revenue side of the equation they can focus on the price they charge and also seek to increase demand for their product (outward shift of the demand curve). Adjusting the price they charge will either lead to an increase or decrease in revenues depending on the price elasticity of demand. If demand is price elastic then higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. If demand is price inelastic then higher prices will lead to higher revenues but lower prices will lead to an a reduction in revenues. Many monopolists face a demand curve that is price inelastic (local utilities are a classic example). The other opportunity to increase revenues will be through marketing efforts, the introduction of new products, or by exploiting changes in economic conditions, to enjoy an increase in demand. Then at any given price people will want to buy more of thei firm’s products. Remember also that any change in output will lead to a change in the cost of production. The firm must keep this in mind. If the firm is operating at a point of diminishing returns then the firm’s marginal and average costs will increase as ouput increases. The firm will seek to mitigate this by working to employ new technologies or other means to increase productivity and lower the firm’s marginal and average costs.
Firms who compete in the monopolistic competition market structure face the same opportunities that monopolists do in that they can attack both the revenue and cost sides of the profit equation, but with a very important difference. They have to contend with many more competitors producing similar substitutes leading to a demand curve that is far more price elastic. As a result, higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. The problem with lowering their prices is that competitors can follow suit leading to price wars. The lower prices may also hurt their image in the marketplace. Instead, monoplistic competitors will seek to differentiate themselves from their competitors in order to retain control over the price they charge (restaurants are good examples of this). The cost side is also important because they do face a significant amount of competition and as a result they face a lot of price pressures. They will therefore work to increase productivity to manage their costs. The oligopolist faces the same issues monopolistic competitors face, but the number of competitors is greatly reduced. As a result demand tends to be more price inelastic. The competition among a small group of strong competitors can be very fierce making product differentiation very important.
Think about the firm you work for. How do they maximize profits and what competitive conditions do they face that affect their profit outcomes?