In today’s ever-changing economy, maximizing profits in competitive markets may prove difficult without the understanding of a competitive market’s defining characteristics. In this essay, competitive market features are examined, highlighting the effect they have on managerial decision-making and profit maximization strategy.
The main characteristic that defines a competitive market is a large number of buyers and sellers of essentially the same product, a perfectly standardized commodity, forcing both sides to accept, rather than define, market prices (Hirschey 381). Thus, both buyers and producers take roles of price takers, with the price taken as a given and defined by the intersection of supply and demand. In a competitive market, the product manufactured by one company can be substituted with a similar product from another company. Since all companies produce the same product, the customers are not willing to pay for that product more than the going market price, leaving manufacturers no choice but to adapt to market conditions and accept the price. If a company raises the price of the product, it will lose its customers. In a perfectly competitive market, only a normal margin of profit is expected in the long run, due to rigorous price competition and fast response to price changes from competitors.
Another defining characteristic of a competitive market is that there is no restriction on entry or exit, which means that there are no barriers for companies willing to enter or exit the market, such as government regulations or the difficulty of acquiring the necessary resources. Free entry and exit also mean that there are no obstacles for those buyers who want to switch from one manufacturer to the other. In a competitive market, such product information as to cost, price, and product quality are widely available. The combination of all of these features is attributed to perfect competition (Thomas and Maurice 392). Although there are very few markets that strictly correspond to all of the conditions of perfect competition, markets that do not precisely meet all of the requirements are nonetheless viewed by the participants as perfect competition. Examples of vigorously competitive, if not perfectly competitive markets include agricultural product markets, restaurant business, and an unskilled labor market. For instance, the restaurant industry is one of the most competitive industries in developed countries, due to the large number of restaurants, standard food quality, easy entry and exit and widely available information.
A more recent example of a competitive market is a rapidly expanding smartphone market. Due to easy entry and exit, a large number of smartphone buyers and many tech companies competing for the market share, standardized design, app and feature set of modern smartphones and good information it is extremely difficult for tech companies to make above average profits in most segments of the smartphone market. A proof of that is an announcement that Hewlett-Packard (HP), one of the world’s largest IT companies, exits the smartphone market due to the rigorous competition. The technology giant accepted that it was too costly for the company to compete with other established players. HP CEO concluded that “to be successful in the consumer device business we would have had to invest a lot of capital and I believe we can invest it in better places” (Worthen et al. par. 8).
As evidenced by the examples above, for managers and business owners managing a sustainable and profitable business is a major challenge even in those markets that do not entirely correspond to the model of perfect competition, but fit most of its criteria. As stated above, it is likely that no particular industry completely satisfies all of the conditions of perfect competition (“Profit Maximization in Perfectly Competitive Markets” p. 226). As such, profit maximization strategies in competitive markets will still be applicable to companies operating in markets that are not perfectly competitive, but have most of the features of perfect competition. When it comes to profit maximization in competitive markets, this hypothesis is defined as firm’s aim to maximize profits, profits being the difference between the total revenue received by the firm and the total costs it incurs (Pierce and Shaw 350).
Any company operating in a competitive market aims to maximize profits due to the competitive nature of the market. When there are many companies producing the same product, and the information about the price of the product and its qualities is widely available, those companies that do not follow profit-maximizing route will most likely fail due to the highly competitive nature of the market. Since managers of companies in competitive markets have little to no control over price, they are likely to feel powerless in their ability to deliver profits to the business’s owners. However, one strategy that can be explored is adjusting output with the goal of maximizing profit and minimizing losses. Due to the fact that in a competitive market a number of companies produce the same product, each company’s output is incrementally small. Because of that, the company’s output decisions have little or no effect on the market price, and in the perfect competition model, the demand curve is drawn horizontal (“Profit Maximization in Perfectly Competitive Markets” p. 230). This position of the curve implies that the company can sell as many products as it wants with no effect on the price. In addition, the horizontal demand curve represents the marginal revenue curve facing the manager (Thomas and Maurice 394).
The short-run profit maximization strategy in this situation is varying output by adjusting variable inputs. The company in a competitive market should adjust the volume of production until the point when the marginal cost, or the change in the total cost after production increases by one unit, equals the marginal revenue, or the revenue generated by increasing product sales by one unit. The marginal revenue, however, should exceed average variable cost, or the company’s variable costs per unit of output at each output produced. Otherwise, the company suffers a loss in excess of the expenditure of fixed inputs at each output. Until average variable cost is less than or equals marginal cost, the company’s short-run supply curve and its marginal cost curve will be the same. In some cases, however, no matter what output is produced, the company will operate at a loss in the short term. If this happens, the manager has to decide whether to shut down the company, or continue to operate at a loss. Since the company is liable for fixed costs whether it operates or not, the latter is a better choice overall, until average variable costs are offset by the price.
In the long run, the same principles of profit maximization can be used: the company would plan to operate at a scale (or plant size) such that long-run marginal cost equals price (Thomas and Maurice 411). These planned adjustments are reflected on the long-run supply curve, which can take two shapes: upward-sloping for the industry in which the prices of one or more inputs rise as the industry expands, and a horizontal long-run supply curve for a constant-cost industry, expanding its use of inputs with no price change. In the long run, due to the fundamental characteristic of a competitive industry that allows unrestricted entry and exit, more firms are expected to enter the industry, increasing market supply.
Increased supply, in turn, causes prices and profits to fall, which is well known by the tech companies in the highly competitive smartphone market, some of which notoriously create a shortage of goods to boost sales and keep the profits from tanking (Whitney par. 6). When profits fall to zero, there is no incentive for new companies to enter, and since economic losses are eliminated, no companies exit the market. In the absence of new competitors, the existing companies would continue to earn as much as possible in their best alternatives, and long-run competitive equilibrium occurs (Thomas and Maurice 411). Thus, a short-run analysis defines an industry’s temporary position, while in the long-run competitive equilibrium is inevitable for the industry.
The requirements that define perfect competition are unlikely to be met in many real-world markets. However, if a certain degree of adaptability is allowed, the competitive model can be used to examine short-term and long-term profit maximization strategies in real-world competitive markets.
Hirschey, Mark. Fundamentals Of Managerial Economics. Mason, OH: South-Western/Cengage Learning, 2009. Print.
Pearce, David W. The MIT Dictionary Of Modern Economics. Cambridge, Mass.: MIT Press, 1992. Print.
Thomas, Christopher R and S. Charles Maurice. Managerial Economics. New York: McGraw-Hill/Irwin, 2011. Print.
Whitney, Lance. iPhone SE suddenly harder to find. 2016. Web.
Worthen, Ben, Scheck, Justin and Chon, Gina. ” H-P Explores Quitting Computers as Profits Slide”. The Wall Street Journal. 24.1 (2011): n.pag. Web.