Chapter 14

1. Chapter 14 Advanced Techniques for Profit Maximization

2. Advanced Techniques for Profit Maximization • Multiplant firms • Cost-plus pricing • Multiple markets • Price discrimination • Multiple products • Strategic entry deterrence

3. Multiple Plants • If a firm produces in 2 plants, A & B • Allocate production so MCA = MCB • Optimal total output is that for which MR = MCT • For profit-maximization, allocate total output so that MR = MCT = MCA = MCB

4. A Multiplant Firm (Figure 14.1)

5. Cost-Plus Pricing • Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization • Price charged represents a markup (margin) over average cost: P = (1 + m)ATC Where m is the markup on unit cost

6. Cost-Plus Pricing • Does not usually produce profit-maximizing price • Fails to incorporate information on demand & marginal revenue • Uses average, not marginal, cost

7. Practical Problems with Cost-Plus Pricing(Figure 14.3)

8. Cost-Plus Pricing (Constant Costs) • Yields profit-maximizing price when optimal markup, m*, is applied to AVC: P = (1 + m*)AVC • And optimal markup is chosen according to the following relation: • Where E* is price elasticity at profit-maximizing point of firm’s demand

9. Cost-Plus Pricing (Constant Costs) • When demand is linear & costs are constant (SMC = AVC), profit-maximizing value for E* is: • Where A is price-intercept of linear demand curve & AVC is constant

10. Multiple Markets • If a firm sells in two markets, 1 & 2 • Allocate output (sales) so MR1 = MR2 • Optimal total output is that for which MRT = MC • For profit-maximization, allocate sales of total output so that MRT = MC = MR1 = MR2

11. Price Discrimination • Method in which firms charge different groups of customers different prices for the same good or service

12. Deriving Total Marginal Revenue(Figure 14.4)

13. Profit-Maximization with Two Markets(Figure 14.5)

14. Multiple Products • Related in consumption • For two products, X & Y, produce & sell levels of output for which MRX = MCX and MRY = MCY • MRXis a function not only of QX but also of QY (as is MRY) -- conditions must be satisfied simultaneously

15. Multiple Products • Related in production as substitutes • For two products, X & Y, allocate production facility so that MRPX = MRPY • Optimal level of facility usage in the long run is where MRPT= MC • For profit-maximization: MRPT = MC = MRPX = MRPY

16. Multiple Products • Related in production as complements • To maximize profit, set joint marginal revenue equal to marginal cost: MRJ = MC • If profit-maximizing level of joint production exceeds output where MRJ kinks, units beyond zero MR are disposed of rather than sold • Profit-maximizing prices are found using demand functions for the two goods

17. Profit-Maximizing Allocation of Production Facilities (Figure 14.7)

18. Profit-Maximization with Joint Products (Figure 14.9)

19. Strategic Entry Deterrence • Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a market • Two types of strategic moves • Limit pricing • Capacity expansion

20. Limit Pricing • Established firm(s) commits to setting price below profit-maximizing level to prevent entry • Under certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever

21. Limit Pricing: Entry Deterred(Figure 14.11)

22. Limit Pricing: Entry Occurs(Figure 14.12)

23. Capacity Expansion • Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacity • When increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of production • Requires established firm to cut its price to sell extra output

24. Excess Capacity Barrier to Entry(Figure 14.13)

25. Excess Capacity Barrier to Entry(Figure 14.13)