The essence of profitability is a firms Revenue – Costs with revenue depending upon price and quantity of the good sold.
1. The degree of competition a firm faces is important if a firm has monopoly power then it has little competition, therefore demand will be more inelastic. This enables the firm to increase profits by increasing the price. (For A2 draw monopoly diagram) However govt regulation may prevent monopolies abusing their power e.g. the OFT can stop firms colluding (to increase price)Regulators like OFGEM can limit the prices of Gas and Electricity firm
2. If the market is very competitive then profit will be low. This is because consumers would only buy from the cheapest firms. Also important is the idea of contestability. This is how easy it is for new firms to enter the market. If entry is easy then firms will always face threat of competition, even if it is just "hit and run competition" This will reduce profits. Firms may seek to create barriers to entry. The most common is creating brand loyalty through advertising.
3. The strength of demand is very important. For example demand will be high if the product is fashionable, e.g. mobile phone companies have been very profitable. However in recent months profits for mobile phone companies have fallen because the high profit encouraged over supply. Products which have falling demand like Spam (tinned meat) will lead to low profit for the company
4. The State of the economy. If there is economic growth then there will be increased demand for most products especially luxury products with a high YED. For example manufacturers of luxury sports cars will benefit from economic growth but will suffer in times of recession.
5. A successful advertising campaign can increase demand and make the product more inelastic, however the increased revenue will need to cover the costs of the advertising. Sometimes the best methods are word of mouth. For example it was not necessary for YouTube to do much advertising.
6. Substitutes, if there are many substitutes or substitutes are expensive then demand for the product will be higher. Similarly complementary goods will be important for the profits of a company.
7. The other aspect of profitability is the degree of costs. An increase in costs will decrease profits, this could include labour costs, raw material costs and cost of rent. For example a devaluation of the exchange rate would increase cost of imports therefore companies who imported raw materials would face an increase in costs. Alternatively if the firm is able to increase productivity by improving technology then profits should increase. If a firm imports raw materials the exchange rate will be important. An depreciation making imports more expensive. However depreciation of the exchange rate is good for exporters who will become more competitive.
8. A firm with high fixed costs will need to produce a lot to benefit from economies of scale and produce on the minimum efficient scale, otherwise average costs will be too high. For example in the steel industry we have seen a lot of rationalisation where medium sized firms have lost their competitiveness and had to merger with others.
9. If a firm is not dynamically efficient then over time costs will increase. For example state monopolies often had little incentive to cut costs, e.g. get rid of surplus labour. Therefore before privatisation they made little profit, however with the workings of the market they became more efficient.
10. If the firm can price discriminate it will be more efficient. This involves charging different prices for the same good, so the firm can charge higher prices to those with inelastic demand. This is important for airline firms.
Richard is an economics teacher in Oxford and is a member of the Sri Chinmoy Centre Richard edits a site on economics called Economics Help This is a useful resource of economics essays and help |
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