COMPETITION, PRICES AND PROFITS

COMPETITION, PRICES AND PROFITS

Costs of production are one element in the analysis of supply but
we now need to contrast this with an understanding of prices and
profits. However cost-efficient an enterprise may or may not be,
whether it can stay in business, or fail, depends on its ability to
make long-term profits.
A company can weather a short-lived downturn in trade only so
long as it can cover all its costs and return a reasonable profit over
the longer run. This depends on the success of each individual firm
in the market place: can it deliver what consumers want to buy at
the right price? If not, if the price at which a firm sells its goods
cannot be maintained above its average production costs, then losses
will be made. If these continue, the firm will close down.
This raises the interesting notion of how market prices are influenced
by the setting up or closing down of firms. Assume for the
Average costs

time being there is a stable, unchanging industry demand for a
given good – if the number of firms producing this good decreases,
and industry supply therefore decreases, a shortfall in market
supply will push up prices (see Chapter 2). Conversely, an increase
in the number of producers may lead to falling prices over time.
The state of competition in industry, therefore, affects prices and
thereby profits of all involved.
In some industries there may be thousands, if not millions of
suppliers. In the market for coffee or tea, for example, if one more
producer enters or exits the industry it will have a negligible affect
on overall supply and therefore price of the product. The entry of a
new airline company in long haul, transatlantic flights, however,
may well have a significant impact on ticket prices.
Profit Maximisation under Perfect Competition
Consider, first, the market structure where there are many
competing suppliers but no one in particular is big enough to exercise
a commanding lead. In such a scenario, typical of agricultural
commodity markets such as coffee, tea or wheat, the product of one
supplier is a close if not identical substitute to that of another and
the price of this product is set in the market place by the competing
forces of demand and supply. An individual producer, therefore, has
no effective power over the important decision as to what price to
charge for his/her product (the enterprise is a price taker, not a price
maker) and can only decide how much to produce, given that price.
If we assume that the supplier aims to maximise profits in this
competitive situation, we can deduce that output will expand so
long as each additional unit produced adds more to revenue earned
than it does to costs. That is, production can continue so long as
selling prices are maintained above costs – but, as we have seen,
costs eventually begin to rise. Profits will thus be maximised where
the cost of the very next bag of coffee/tea rises to just equal its
price. To produce beyond this point incurs a loss on each additional
unit sold.
Economists define this point of profit maximisation in terms of
marginal revenue (MR) being equal to marginal costs (MCs). That is,
the point where the revenue earned from the sale of one extra unit
equals the costs incurred in the production of that unit (Box 3.1).
© 2004 Tony Cleaver
What would be the profit maximising output if the price of the
product, determined in world markets, was stable and given as
60 per unit? That would give a table of total, average and marginal
revenue as shown in Table 3.3.
In the example of Table 3.3, profits are maximised at where
output equals 7 units. Check, if you wish, the TR and TCs at each
output level and you will find the greatest difference between the
two occurs at 7 units. The quickest way to find this profit
maximising output, however, is simply to compare MCs and MRs.
At output 7, MC equals 52, just short of MR at 60. That is, the
cost of the seventh unit is less than the revenue it earns and so it
is worthwhile producing it. The eighth unit, however, has MC of
Box 3.1 Total, average and marginal costs and revenues
To clarify the issues involved here requires us to discriminate
carefully between total costs and revenues; average costs and
revenues; and marginal costs and revenues:
Note our earlier outline of total and average costs given in
Table 3.1. We can add an extra column illustrating the increase in
TCs as output increases: from 1 to 2 units the increased TC is 50;
from 2 to 3 the increase is 30; and so on. This is the column of
MC seen in Table 3.2.
Table 3.2 Total, average and marginal costs.
Output Total Average Marginal
cost cost cost
1 100 100 —
2 150 75 50
3 180 60 30
4 200 50 20
5 230 46 30
6 270 45 40
7 322 46 52
8 400 50 78
9 495 55 95
10 600 60 105
© 2004 Tony Cleaver
78 – much higher than the MR of 60. The enterprise loses by
pushing production this far.
This analysis can be summarised in Figure 3.3.
Note that the ruling price is determined in world markets (at 60)
and the individual producer compares this to his/her costs of
production. With average and marginal costs as illustrated, the
profit maximising output is shown at 7 units. At this level of
output, the MC rises to equal the MR (equal to price).
Table 3.3 Total, average and marginal revenue.
Output Total Price, or average Marginal
revenue revenue revenue
1 60 60 —
2 120 60 60
3 180 60 60
4 240 60 60
5 300 60 60
6 360 60 60
7 420 60 60
8 480 60 60
9 540 60 60
10 600 60 60
World market Costs and revenues of one supplier
Price Costs/revenues
World supply
MC
AC
60 AR/MR= 60
AC=46
World demand
0 7
World output Output of one supplier
Figure 3.3 Short-run profit maximisation for a competitive producer.
© 2004 Tony Cleaver
If there are large profits being made in a competitive market
place there is bound to be an incentive for outsiders to enter and
seek to do the same. This raises the theoretical notion of NORMAL, as
opposed to ABNORMAL profits. Normal profits can be defined as a
just and sufficient reward for an entrepreneur to conduct his/her
business. Any less than this and the entrepreneur would not be
getting enough compensation for the hard work and risks undertaken;
any more than this and the business would be earning an
excess above what is considered necessary. An enterprise earning
less than normal profits would thus leave the market it is operating
in and go look elsewhere to conduct its business; conversely a
market place where existing businesses are earning above-normal
(or abnormal) profits would act as a magnet for other firms to enter.
(Note: since entrepreneurs would not set up a business without
the promise of normal profits, economists would define this level of
reward as an essential cost of enterprise. It may at first acquaintance
seem confusing to call ‘normal profits’ a sort of cost but that is
indeed what they are in the view of economic theory!)
In a competitive market place, if outsiders are not restricted from
entry, abnormal profits would lead to more businesses setting up,
thereby increasing industry supply. The higher the original
abnormal profits, the stronger the signal would be to attract outside
interest and the more new entrants would flood in. The longer-term
outcome is not difficult to see (Figure 3.4). As industry supply
grows, (illustrated by a supply curve that shifts further and further
TR, TC and total profits (TP) can all be derived from Figure 3.3.
TR equals the price (AR) times output: 60 7 420
TC equals the average costs times output: 46 7 322
TP equals TR TC, or AR AC times output: 14 7 98
Thus TP, which are maximised at 7 units of output, are illustrated
by the shaded area in the figure. It shows the difference
between the price (AR) and unit costs (AC) at that level of
output (7) where MR is closest to MC.
© 2004 Tony Cleaver
to the right, see Chapter 2) the more market prices will fall,
squeezing down the profits earned by everyone until only normal
profits remain for the latest newcomer.
High short-term prices and profits for Internet companies – the
so-called dot.com boom – led precisely to this outcome in world
markets at the turn of the millennium. First, there was a rush to
create all sorts of dot.com businesses – which attracted much media
interest, promised great future profits and thus prompted soaring
share prices for start-up outfits that seemed to have nothing but
young entrepreneurs with big ideas. Then a bust followed the boom
when an oversupply of such enterprise could not return anything
like the profits that were originally hoped for.
Figure 3.4 Long-term profit maximisation for a competitive producer.
Note the difference from the Figure 3.3. Abnormal profits (the
shaded area in Figure 3.3) have all been eroded as market prices
have fallen. The long-run equilibrium for producers in a competitive
market is thus where prices and MRs equal MCs just where
ACs are at their lowest and no abnormal profits remain to tempt
the entry of further competition. Two conditions of equilibrium
now exist – for the individual firm and for the industry as a
whole. The firm or enterprise is at its profit maximising equilibrium
where its MCs equal its (lower) MR, and the industry is in
equilibrium with only normal profits being available and thus
where no further movements of suppliers in or out of the market
place will take place.
World market Costs and revenues of one supplier
Price Costs/revenues
MC
World supply 2 AC
60
45 45 AR/MR
World demand
0 67
World output Output of one supplier
World supply 1
© 2004 Tony Cleaver
Note that a highly competitive market environment is generally
considered to be the most efficient and equitable form of economic
organisation. Profits are earned by catering for public demand and
the more successful the producer is in this respect, the more other
competitors will follow. Increasing rivalry drives each business to
look for ways to reduce costs and economise on society’s resources
and, simultaneously, so long as competition prevails it prevents any
one producer from accumulating excessive profits and abusing its
market power.