Market Structures and Profit Maximization in Economics

Introduction to Profit Maximization

In economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue–total cost method relies on the fact that profit equals revenue minus cost, while the marginal revenue–marginal cost method is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost.

Economists identify four basic types of markets based on several criteria: the number of firms relative to the size of the market, the ease of entry (are there barriers such as economies of scale or government regulation?), the degree of competition (do firms ignore each other's choices or compete actively?), and product differentiation (do consumers consider the product to be the same regardless of who produces it, or not?).

The size of the market is determined by what buyers believe to be good substitutes for a firm's product. For example, the market for long-distance calls is national because people consider any U.S. long-distance supplier to be a good substitute. By contrast, the market for funerals is very local; a funeral parlor in another neighborhood is unlikely to be considered an acceptable substitute.

Perfect Competition

Perfect competition is a market in which there are large numbers of buyers and sellers of a homogeneous product—wheat is wheat, for example—none of which can influence price. It features easy entry due to small economies of scale and no significant barriers, and essentially no active competition, as firms ignore or even assist one another. Examples include most basic commodities: agricultural products, minerals such as oil, and similar goods.

The alleged unique attribute of a perfectly competitive industry is that the market price equals the marginal cost of production, as a consequence of the competitive, profit-maximizing behavior of countless non-collusive small firms. Individual self-interest and social welfare are thereby reconciled: the profit-maximizing behavior of individual firms leads to the socially optimum outcome, in which the marginal benefit of output to society equals the marginal cost of production.

Perfect competition is a purely theoretical construction. Some compare it to a frictionless state in physics—it is a starting point. It provides the basis for much of the decision theory that has been applied in finance, management, and marketing, and it is remarkably useful in predicting economic behavior in actual markets.

Monopoly

A monopoly is a market in which there is essentially only one large firm selling a product. There may be many very small firms, but they have no effect on the dominant firm's choices. Significant barriers to entry exist, and there is, of course, no meaningful competition. A well-known example is Microsoft with respect to the PC operating system. Its monopoly power derives from the economies of scale associated with developing and implementing an operating system and from copyrights on its existing products.

As the single seller of a unique good with no close substitutes, a monopoly firm essentially faces no competition. The demand for its output is the market demand. This gives the firm extensive market control—the ability to control the price and/or quantity of the good sold—making a monopoly firm a price maker. However, while a monopoly can control the market price, it cannot charge more than the maximum price that buyers are willing to pay.

Monopoly is relatively rare because it requires that there be only one seller of a particular good or service. Close substitutes are typically available, and the firm's own-price elasticity of demand is relatively small. The firm's demand elasticity approaches the market demand elasticity, and the cross-price elasticity of demand with similar products is close to zero.