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Profit Maximization Strategy in Different Market Structures
Discuss whether profit maximisation is the best strategy in the long run for firms in different market structures.
Market Structures and Competition
[CIE A level November 2019]
Step ➊ : Define ‘profit maximisation’ and ‘long run’ in the introduction.
It is argued whether profit maximisation is the best strategy in the long run for firms in different market structures. The long-run is a period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all costs, whereas, in the short run, firms are only able to influence prices through adjustments made to production levels. Profit maximisation means that the firm will aim to maximise the difference between the total revenue and total cost. The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to marginal revenue (MR) and the marginal cost curve is rising. However, we will also see that firms in market different market structures may have different objectives.
Step ➋ : Discuss in which market structure profit maximisation would be the best strategy.
➤ 2.2 In perfect competition and monopolistic competition long-run profit maximisation would apply.
In both under perfect competition and monopolistic competition, the number of firms is large and there is high competition between firms. There are no barriers to entry and exit. In the case of firms facing strong competition from others, they are forced to act as profit maximizers. They must do everything possible to increase sales and reduce costs in order to survive in their competitive environment. Both monopolistic firms and perfectly competitive firms will be making normal profit or zero economic profit in the long run.
The figure below shows the equilibrium price and output in a perfectly competitive firm in the long run.
Because the marginal revenue received by a perfectly competitive firm is equal to the price P, it is recommended that a perfectly competitive firm aims for profit maximisation and produces at the quantity of output where P = MC.
Step ➌ : Discuss in which market structure, other strategies than profit maximisation would be the best strategy
➤ 3.1 For oligopoly firms and monopoly firms, other strategies than profit maximisation may be more appropriate in the long run.
Both oligopoly firms and monopoly firms may opt for growth maximisation and increasing market share instead of profit maximisation. A monopoly is a firm which dominates the market. Oligopoly is a market structure with few firms and high barriers to entry.
Such firms often seek to increase their market share in the long run, even if it means less profit in the short run. Increased market share increases monopoly power and may enable the firm to raise prices and make more profit in the long run. Futhermore, managers prefer to work for bigger companies as it leads to greater prestige and higher salaries and thus aim to increase market share.
Oligopily firms and monopoly firms may wish to increase market share in order to force rivals out of business. For example, the growth of supermarkets have to lead to the demise of many local shops. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business. This can be achieved in the long run as firms benefit from economies of scale and are able to lower their costs and prices.
These firms may also aim for growh maximisation instead of profit maximisation in the long run. Growth maximisation involves mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order to increase in size and again gain more market share.
Some companies may change their business objective to sales maximization rather than profit maximization in the long run. Sales maximisation is shown in the figure below. Maximising sales revenue occurs when the marginal revenue, MR, from selling an extra unit is zero (MR=0).
➤ 3.2 Profit maximisation would be less effective in contestable markets
In contestable markets, only normal profits can be earned in the long run. If firms are making abnormal profits, then this is the signal for others to enter the market. A contestable market might have companies entering using entrants a hit and run strategy. The new entrants can "hit" the market, given there are no or low barriers to entry, make profits, and then "run," without incurring any exit costs.
Even a monopoly might be forced to operate competitively if barriers to entry are weak. Those operating a monopoly might conclude that if they're too profitable, a competitor could easily enter the market and contest their business–undercutting the monopoly's profits. Thus a monopoly may carry out predatory pricing. Deliberately cutting the price to reduce profit might be a strategy to deter new entrants into the market.
Step ➍ : Conclude
To conclude, different strategies can be identified in relation to different market structures. In perfect competition and monopolistic competition, long-run profit maximisation would apply, whereas in oligopoly and monopoly other strategies may be appropriate, e.g. sales revenue maximisation and growth maximisation. In contestable markets, profit maximisation cannot be achieved due to hit-and-run competition and there may be other objectives than profit maximisation.
♕ Marking Scheme
A comparison of long-run profit and the difference that exists between the different forms of competition. Idea of contestable markets may mean that profit maximisation cannot be achieved due to hit-and-run competition, or there may be other objectives. Different strategies can be identified in relation to different market structures, e.g. in perfect competition and monopolistic competition long-run profit maximisation would apply, whereas in oligopoly and monopoly other strategies may be appropriate, e.g. sales revenue maximisation.
L4 (9–13 marks): For a sound discussion of two market structures and two strategies. (Max. 11 if no conclusion).
L3 (7–8 marks): For an analysis of either two market structures and one strategy or one market structure and two strategies.
L2 (5–6 marks): For a limited comparison of a strategy between two forms of competition.
L1 (1–4 marks): For an answer which has some basic correct facts but includes irrelevancies. Errors of theory or omissions of analysis will be substantial.