MC= Marginal cost
MR= Marginal revenue
MRC= Marginal revenue for a firm under competition
AC= Average cost
AR= Average revenue
ARC= Average revenue for a firm under competition
The profit maximisation diagram is used by economists to explain how
firms determine the level of output that leads to the highest level
of profit for the firm, specifically the point where total revenue
exceeds total costs by the highest amount and hence profits are
maximised. This is where the yellow and blue lines cross. Not the gap shown by the black lines in between the average cost and average revenue indicates the profit per unit.
However, if we were to assume that the firm instead opted to produce
at the “Highest non loss-making point” (HNLP), which is where the
green and orange lines cross and hence the firm makes zero profit as
costs equal revenue, then the societal benefit of the firm would be
greater. This is because, as we can see, it produces a higher level
of output with a lower unit price. Therefore in this diagram the
social optimum level of production and the incentivised level of
production differ. It is also impossible to incentivise the firm to
produce at this level other than subsidising the firm to such an
extent that this level of output becomes the most profitable. This
tactic is unattractive as it simply everyone, including those who do not wish to consume
the product, paying via taxation for the product to be sold at a
lower store price and to drastically increase the firms profits.
A different option would be to simply nationalise the firm, turning
it from a private enterprise to a state run firm. Since the profit
maximisation incentive would be replaced by an “electorate
pleasing” incentive. While the electorate may at first like the
idea of a large state enterprise turning a profit to pay for public
services, they would quickly realise that they would themselves just
be paying for the public services through higher prices, a somewhat
more regressive manner than income taxation. Furthermore a lower
level of output, which is necessary to generate profits, would mean
lower demand for inputs. This translates directly into a higher level
of unemployment. Because of this, the “electorate pleasing”
incentive results in the HNLP.
The diagram shown, however, assumes a monopoly, and while it can be
stated with some confidence that in a choice between government
monopoly and a private monopoly, the former is preferable, often in
reality the choice is not so simple. The choice is often between
private competition and government monopoly.
In order to model both monopoly and competition within the same
diagram we must use the formula: (ARcn =ARmn*F).
This means: The average revenue for a single firm producing quantity
“n” in a competitive environment is equal to the average revenue
for a monopoly producing a quantity of “n” multiplied by the
number of firms. This is because whether 5 firms each produce 20 of a
product or a single firms produces 100, the quantity is still the
same and hence the effect on price is still the same.
With this formula we can create a new graph incorporating
competition. The following example assumes there are 4 firms. It
assumes this because that is the number of firms that results in a
level of output at the lowest point on the marginal cost curve, any
level of output above this, in the long run, will lead to new firms
entering the market and any level below will lead to firms buying
others.
As we can see, the firms in a competitive produce at a lower price
and although they produce a lower quantity, this quantity multiplied
by 4 would clearly exceed the level produced by a private monopoly.
From this diagram then we can state that private competition is
preferable to private monopoly. However if we compare it to the HNLP
we can see it produces a lower price, though cannot say simply from
looking at the diagram say that it produces a higher level of output,
in order to properly compare private competition against state
monopoly in this context we must look at the figures behind the
graph.
Competition
|
State monopoly
|
|
TC
|
48.6*4=194.4
|
467
|
TR
|
121.6*4=486.4
|
467
|
MC
|
4
|
48.1
|
MR
|
4
|
5.6
|
AC
|
6.08
|
16.4
|
AR/Price
|
15.2
|
16.4
|
Output
|
8*4=32
|
28.5
|
Profit
|
73*4=292
|
N/A
|
As the table
demonstrates, in this incidence the competitive market produces a
higher total output at a lower price, for this industry then it can
be said that, with measures to ensure competition, society is best
served by the sector being in private hands. It is also possible
however for the state monopoly to produce more at a lower price. When
either the state or the private sector can produce superior results
in both price and output, then the choice is obvious. However when
there is no absolute superior option then a trade off must occur. The
government must decide if they prioritise the price level or the
level of output, and to what degree they prioritise it. For example a
government may have to decide whether a 5% increase in the level of
output is worth a 4% increase in the price level.
Since the optimal form
of organising the industry is determined by their relative
equilibrium outputs and price levels, but this data is sometimes
difficult to accurately measure, we must look at what determines the
cost and revenue curves, namely the intricacies of supply and demand
respectively.
The main determinates
of the cost curve are the “Economies” and “Diseconomies” of
scale. These refer to the benefits and problems gained by a firm
gaining size, respectively.
An example of an
economy of scale is the division of labour. If a firm produces more,
it will have to hire more staff, this means they can divide the
number of tasks between more people. Where a person may have done
three tasks five times a day, now they can do one task all day.
Because the person is focused on this single task they become better
at performing it and gain experience faster. Also having each
employee doing less tasks makes training faster, as well as filling
temporary vacancies easier.
An example of a
diseconomy of scale would be communication channels. With some
companies communication between employees is vital, and the best way
to do this is one-on-one communication channels. However as the
number of employees increases the number of communication channels
this requires increases quickly.
Employees
|
Communication Channels
|
1
|
0
|
2
|
1
|
3
|
3
|
4
|
6
|
5
|
10
|
Economies and
diseconomies of scale determine the optimum size of a firm, with
higher diseconomies and lower economies of scale making the optimum
size smaller. The smaller the optimum size of a firm, the more likely
that it suits private competition rather than state monopoly.
The determinants of the
shape of the revenue curve are the variety, volatility and
intangibility of demand.
A monopoly attempting
to meet a wide variety of demand will suffer, as can be seen by poor
quality of cars in the Soviet Union. Since the automotive industry
has a large variety of demand, attempts by a monopoly to meet all
these demands will struggle, leading to a “one size fits all”
while a large number of firms can each engage in specialisation, some
making “luxury sports cars”, while others can provide “cheap
utilitarian transport for the masses”, to quote Giorgetto Giugiaro.
Another determinant of
the revenue curve is the “intangibility of demand” for certain
products. Before a movie is released to the general public, a film
company can assess it and come up with a number of demonstrably true
figures; length, budget, a list of the actors, production time, CGI
expenditure. However, none of these are real indicators of the films
quality as a product, nor the demand for it, the audience does not
judge a film based on these figures, but rather their enjoyment from
the film. Their enjoyment from the film is derived not from these
figures, but from a set of characteristics that are based partly on
these. A film can be too long or too short, it can be too low budget
to allow for decent suspension of disbelief or it can have so much in
terms of special effects that the audience is reminded they are
watching a movie. This type of demand is difficult for a monopoly to
produce for, since it can not set easy targets for its products.
Other products however have a less intangible demand, for example
televisions. When people are considering buying a television they
have certain characteristics in mind; size, features, clearness of
sound and picture, inputs, power consumption. These are all
measurable and demonstrable. Another good example of tangible demand
comes in the form of refined materials and components. Since the
aesthetics of a good are often dealt with by the manufacturer, the
materials and components bought by the manufacturer are free to focus
on tangible characteristics such as size, weight, strength etc. It is
because of this that while car manufacture may be best left to
private firms, the production of steel and aluminium for the cars may
be better suited to a state monopoly.
Another factor that
determines the optimum method of organising an industry is the size
of the barriers to entry. Barriers to entry refer to the start up
costs of a business, such as acquiring the land, buildings and
machinery to produce the goods. The lower these are, the easier it is
for firms to enter the market and hence the optimum firm size is
reached quicker if there are too few firms. The less barriers to
entry there are, the more desirable a private enterprise approach is.
To summarise, the
traits which indicate a superiority for the private enterprise
approach or the state monopoly approach are as follows.
Private
|
State
|
|
Economies of scale
|
Low
|
High
|
Diseconomies of scale
|
High
|
Low
|
Variety of demand
|
High
|
Low
|
Intangibility of demand
|
High
|
Low
|
Barriers to entry
|
Low
|
High
|
From this list we can work out a variety of sectors that are best served by private or state control
Better off nationalised
|
Better off private
|
Utilities; power, water etc
|
Cars
|
Public transport
|
Advertising
|
Steel
|
Music
|
Natural resources
|
Corner shops
|
Banking
|
Restaurants
|
