Profit Maximization in Different Market Structures

Profit-maximizing strategies differ among firms depending on the competitive nature of their industries.  Our text divides them into the following:

• Perfect Competition: In a perfectly competitive market (which is only approximated in the real world in some industries), a firm has zero market power, meaning that it has no ability to set its own price.  There are many relatively small firms producing a homogeneous, undifferentiated product. This means that the demand curve facing a perfect competitor is horizontal, the firm can sell as many units as it can produce at the market-determined price (which is also the marginal revenue curve), and it cannot raise its price without losing all of its sales.  Profit-maximizing scale is achieved, as always, at the point at which marginal cost equals marginal revenue, whether for the short run or the long.  In the long-run, this scale is achieved where the demand curve is tangent to LAC, which (since demand is horizontal) occurs at LACmin.  The firm produces as long as price exceeds AVC; otherwise, the firm shuts down to minimize its loss to its fixed (sunk) costs.
• Monopoly and monopolistic competition: These firms differ from perfect competitors because they have a degree (though limited) of market power and have some discretion over the prices they charge.  The monopolist is the only firm in the market, usually by virtue of legislation, whereas the monopolistic competitor is one among many, only slightly differentiated, producers.  The assumption is that the pricing and output decisions of monopolistic competitors has little or no effect on other firms in the industry and therefore operates independently.  Their demand curves are downward sloping and thus a price increase will reduce the output they can sell, and vice-versa.  Again, profit-maximizing scale is achieved where marginal revenue intersects marginal cost in both the short and the long run.  In the long-run, optimal scale also occurs where demand is tangent to LAC; though in this case, it cannot occur at LACmin (because demand is downward sloping).
• Oligopolies: An oligopoly is characterized by few, relatively powerful firms in the market whose pricing, output, and other business decisions affect the other firms in the oligopoly; this is called interdependence.  Each firm has a healthy degree of market power and can set its own price.  This is different from the monopolist or the monopolistic competitor setting their prices because in an oligopoly, the decisions of one firm engender reactions from the other firms.  Optimal scale is still achieved when MR = MC, but these curves depend on the firms demand curve which depends on the demand curves of the other firms in the industry.     Dealing with this uncertainty entails listing the help of game theory, a framework used to help predict the decisions of other firms.  The industry-profit maximizing result would tend to happen when the firms in an oligopoly cooperate; however, cooperation is unstable because any firm could unilaterally change its price and earn higher profits.  Therefore, even under explicit cooperation agreements, oligopolies tend to move toward the Nash equilibrium, which is the optimal decision assuming that all other players also make the optimal decision for their own best interest.  The Nash equilibrium is not the industry- or firm-profit maximizing position.  Successful strategic use of game theory requires detailed understanding of the industry and the cost, revenue, and demand curves facing competing firms.  Since cooperation tends to result in higher firm and industry profits, but since outright collusion is illegal, managers can attempt to identify their firms as strict tit-for-tat players or use techniques such as price matching, sale-price guarantees, public pricing, and price leadership.  These are all strategies to discourage cheating and avoid costly tactics such as price-wars, which lower profits for all firms.  

The best example I can think of for a monopoly is that of Microsoft with its Windows and Office software, or Apple with OSX and related software.  No one else can sell this software without express license from the owner.  Furthermore, both Apple and Microsoft can choose a price for their new OS or for an upgrade.  These monopolies are supported with strong consumer-lock-in because of high switching costs (buying a new computer, learning the new OS) and network effects, such that the more people that use the OS (say, iOS) the more useful it becomes for those who already use it.  Furthermore, any firm attempting to enter the market (say, Ubuntu Touch or Intel Tizen OS) faces sizable barriers to entry, in addition to those above, because to compete with either of these giants would require a massive entrance of advertising and other marketing efforts.

If I ran a small business, I think I would prefer a monopolistically competitive industry.  I think this because operating in an oligopoly sounds mighty difficult and the perfect competitor is subject to the whims of the market and has only to produce optimally.  The monopolistic competitor has things easier because it doesn't need to pay nearly as much attention to other firms as the oligopolist does, yet still has an opportunity to choose its price and output and compete on other points such as service and quality.  Then again, the oligopoly sounds like the most interesting, if the most stressful, arrangement.

These market structures are the crux of the course, and they incorporate everything we've learned so far.  The procedures for choosing optimal scale are applicable to almost any business endeavor, and the strategic framework outlined in chapter 13 is also incredibly useful.  They can be applied to decision-making on points besides price and help guide us, even in non-competitive instances, to the best decision given the decisions of others.  It also helps explain the sometimes odd behavior of industries, such as the example in the text of movie-star salaries, and gives insight into the moves of the companies that affect us the most, such as car, computer, and clothing companies.  

Production and Cost Theory

I've learned a great deal about production and cost decisions, but most of the principles I have already been exposed to.  For instance, the relationships between marginal and average cost and marginal and average product have been a part of most of my economics classes, as well as the dictum to ignore fixed costs for short-term decisions.  In general, while I did learn some things and the review was useful, Chapter 8 on the short-run was old hat for me.

Chapter 9, the long-run, was newer to me.  I had seen isoquants before but had not had the benefit of the in-depth treatment in this chapter.  More illuminating is the description of expansion paths between short- and long-term, and the strategic considerations that such an analysis allows.  The many elegant graphs throughout these chapters (and the text) aid my understanding.

Finally, the discussion of economies of scale and scope were a helpful review, and the "economy of experience" I had not come across before.  To be sure, I need to review both of these chapters to help me understand everything better.

The difference between the short- and long-runs is simple: in the short-run, only variable costs have a bearing on decision making, while in the long-run every cost is "variable".  The long-run is the planning horizon: "...the collection of all possible short-run situations."  In the long-run everything is possible: move production overseas, buy new capital, enter a new market, close down business.  In the short-run, we can make decisions only with those resources that are immediately disposable and have a direct bearing on production, such as hiring/firing workers; that is, the short-run variable costs.

Many companies take advantage of economies of scale and scope.  In fact, we might say that all companies take advantage of these concepts, because they are the long-run applications of short-term decision making theory (deciding on the margin).  Where I work, for instance, we try to take advantage of an economy of scope when we both deliver/pick-up the furniture as well as selling it, since we can provide the service of delivery for less in-house than it would cost to outsource it to another company.

The LRAC diminishes over time as output increases for industries with a high up-front investment, such as water treatment, steel refinement, or oil production.  That is, it takes an enormous amount of resources to create an infrastructure capable of doing steel refinement, and that massive up-front cost is averaged over each ingot produced.

Similarly, new drugs can really only be developed by companies with massive resources because of the huge expense of research, testing, and the high risk associated with the industry.

An economy of scale is also present in shipping: if you can ship more items / freight carrier, average cost per item goes down.

Supermarkets often band together in trade associations and other loose forms of cooperation in order to buy in bulk, lowering the average cost for all firms.