It’s often instructive to do thought experiments. They can provide insight as the mind puzzles through a problem. Problems such as how does a firm increase or maximize its profit.
Most people answer this question in one of two ways: either increase sales or reduce costs. I prefer to consider the problem strategically, working backwards from the profit equation where P (Profit) = TR – TC (TR = Total Revenue; TC = Total Costs).
A firm’s revenues are a function of market structure, while it’s costs are a function of its input costs and how efficiently they are transformed into output. While costs drive pricing, and pricing will influence the quantity sold, firms may have limited market power to be able to influence or control the price they charge.
The closer one’s market structure is to perfect competition, the less a firm has to decide about price. Because a firm operating in such a market is a price taker, the only decision for such a firm to make is to determine what is the optimal quantity to produce. If the firm cannot produce an output quantity which allows it to cover its variable costs, it should, of course, shut down.
Fortunately, few firms are competing in perfectly competitive markets. There are, however some highly fragmented industries which approximate perfect competition. In these cases, pricing in the long run may be driven dow to the long run minimum average total cost, making it very difficult to operate profitably.
At the opposite extreme to perfect competition is monopoly. The monopolist is able to restrict output and drive price higher. The monopolists profit maximizing point is where marginal revenue equals marginal cost.
In between these two extremes, we have varying degrees of imperfect competition, including oligopoly and monopolistic competition. As we move further away from perfect competition, the need for firms to differentiate themselves and their offerings becomes a key component of a strategy for building a competitive advantage.
Differentiation allows a firm to shift the market demand curve rightward, in its favour. This allows the firm to charge a price premium for its differentiated offerings. Thus, a firm can make a higher profit at the same output quantity because its offering is now more valuable to customers.
Price is the translation of a strategic position. While costs will determine margin, they should not always determine pricing. Put another way, if you are not different, you had better be cheap, since the only thing left to compete on is price – the price that the market is willing to pay for undifferentiated products and services.