Product Differentiation And Economic Profit In Economics For Business

Analysis of Monopolistic Competition

Discuss about the Economics for Business for In any Market Structure.

In any market structure, an appropriate once-off expenditure on product differentiation will guarantee the firm’s ability to maximize economic profit into the future.

The main aim of this part of the assignment is to discuss whether the expenditure on product differentiation guarantees firms ability to maximize profit in future in any market structure. The author in this part points that all the types of market structure does not result in positive economic profit due to expenditure on the product differentiation. Product differentiation is the concept used by the producers to exhibit their product as different from other products in order to reduce the substitution of the product. The concept is only applicable in case where there are many buyers and sellers that produce the similar types of product in the market (Baumol & Blinder, 2015). There are various techniques that the producers use to distinguish their product such as advertisement, packaging, branding and discounts. Economic profit is the profit that is left with the producers after deducting opportunity cost of inputs used for the production from the revenue that is earned by selling the product. Perfectly competitive firms do not use product differentiation method and neither do they earn positive economic profit (Roberts, 2014). Hence, an appropriate once off expenditure on product differentiation will not guarantee the firm’s ability to maximize economic profit in any type of market structure in future. The following part analyzes the monopolistic competitive market structure to analyze the importance of product differentiation for generating positive economic profit (Zhelobodko et al., 2012).

Monopolistic competition is a type of market structure where there are large number of buyers and sellers producing similar type of products. Consumers have large choice to choose from the substitutes products. The main reason to use product differentiation method is to eliminate substitutes from the market in order to increase profit. Firms make positive economic profit in short run in monopolistic competitive market. Since the firms in monopolistic market produce similar type of product and not same product, product differentiation is used to generate profit (Bertoletti & Etro, 2015).

The main condition for profit maximization in monopolistic competitive market is producing at a point where MR=MC. The firms in monopolistic competitive market earns positive economic profit as well incur deadweight loss in short run. In long run, the firm does not incur any profit but incur only normal profit. Monopolistically competitive market structures behave like monopolists in short run. This is explained with a help of diagram as shown below.

Product Differentiation in Different Market Structures

Figure: Monopolistic competitions in short run

(Source: created by author)

The firms in a monopolistic competitive market have no control over the price. This is the reason why they face a downward sloping demand curve in short run. Presence of both the average and the fixed costs leads the firms to face a U shaped average cost curve. The main aim of all the firms is to maximize profit and the profit maximizing condition for the firm in short run is at a point where marginal revenue is equal to marginal cost (Novshek, 2014).

The above diagram shows that firms in monopolistically competitive market will produce until a point where MR is equal to MC. The price will be determined from the downward sloping demand curve. The economic profit is marked in pink in the above diagram. Price is marked from the point in the demand curve while the cost is calculated from the average cost curve. The gap between the revenue and cost is the economic profit. The firm also faces a deadweight loss that is measured by the difference in the producer and consumer surplus. It is marked in a brown triangle in the above diagram. The more the product is differentiated in the market the more steeper is the demand curve.

Earning profit is only possible in short run. Seeing firms earn profit new firms join in the long run that produce similar type of product. The competition of the firms increase which makes it difficult for the firms to produce goods that are differentiated in nature. Hence, in long run the firms only earn normal profit due to failure of product differentiation (Gabszewicz & Wauthy, 2014).

In case of a perfectly competitive market where there are large number of buyers and sellers, the concept of product differentiation is not applicable. This is so because the producers produce same type of products that acts as substitute for the consumers. Hence, firms in perfectly competitive market also earn normal profit and the differentiation is done based on price (Makowski, 2014).

In case of oligopoly market structure, few sellers produce the similar type of product. The sellers have control over the price and hence product differentiation is not applicable in such market structure. Product differentiation is only applicable in case of monopolistic competitions that too in short run (Liu & Zhang, 2013). In case of monopolistic competition market, the two main characteristics are that the competitors perceive over non-price difference products and the firms have no price control over the product.

Limitations of Product Differentiation in Generating Economic Profit

The cross elasticity of demand is the degree or responsiveness of change in demand of one good that is affected by the price of the other good. If the cross elasticity of demand is high for the good in the market then the product differentiation will lead to negative economic profit. This is so because the expenditure on the product differentiation adds on to the cost that increases the average total cost (Makadok & Ross, 2013). The average total cost will exceed the price charged by the firm that will lead the firms incur loss in short run. Hence, it can be seen that product differentiation does not lead to positive economic profit in all the situations or the market condition. Profit maximization condition occurs at a biggest gap of total revenue and total cost.

Conclusion

The above discussion shows that the expenditure on product differentiation to earn economic profit does not guarantee positive income in all the market structures and conditions. Product differentiation guarantees firms to maximize profit only in monopolistic competitive firm that too only in short run because the firms acts as monopolists. In long run the firms incur only normal profit. Hence, in any market structure, an appropriate once-off expenditure on product differentiation does not guarantee the firm’s ability to maximize economic profit into the future.

Economics has difficulty in explaining why wage rates for individuals vary across occupations and industries and within occupations and industries.

Various economic factors explain the reasons for variations in the wages of employees across occupation and industries.  There are various theories such as wage differentials and minimum wage that explains the reason for the variation in wages of employees. The labor market and the variations is due to the misbalance in labor demand and supply. The misbalance is due to the difference in skills and education. This type of unemployment is known as structural a frictional unemployment (Ehrenberz & Smith, 2016). Wage rate is not uniform for all the occupation and industries. It varies on the skills that the employees posses and the budget that firms have for the production of goods and services. Since no two jobs have same characteristics this is the major reason for the wages to vary. Economics and statistics can be used to discuss the reason for the variation in wages of labor in the market. The differences occur due to differences in education and desirability of the job.

Conclusion

Minimum wage is the minimum wage set by the government that the employer must give to its employees. The problem with the minimum wage theory is that the government sets a uniform wage for the employees irrespective of their degree of education. This leads the decrease in wages of employees with experience and knowledge. It is beneficial for the employees that are unskilled in nature (Low Pay Commission, 2013).

Figure: Minimum wage theory

(Source: Created by author)

Wage differentials are also known as inter firm or inter area differentials. Method of percentile wages is used to measure the differences in the wages of employees in industries and occupation. Wage difference is the difference between the wages of high earners and low earners. The wage differential theory states five reasons for the differences in wages that are:

1. Occupational differences
2. Inter firm differentials
3. Regional differences
4. Inter industry differences
5. Personal wage differences (Lane, Salmon & Spletzer, 2013).

Occupational differences

The main reason for the differences in wages of employees is difference in the educational qualification and the training that the employee has undergone. People with higher degree and qualification get higher wages than the ones with lower wages. Occupational differences of wages encourages people to take more challenging and complex tasks as skilled people get higher wages than the unskilled people (Fujita & Thisse, 2013). Human capital that is the skills that is required to enter the job market varies in people that cause the differences to arise in wages.

Inter firm differences

Inter firm differences in wages occur due to differences in the quality of labor, imperfections in the labor market and differences in equipment and supervision. Managerial efficiency and other facilities also add on to the differences in the wages.

Not only do the wages vary across occupations and firms but also in industry. The reason for the variation in wages in industries is the variations in the product market, industries ability to pay and the unionization. Occupational wages across industry and employer (Neumuller, 2015). The wages differ from one to the other due to differences in the working conditions, training requirement, company name and clientele.

Trade unions and their collective bargaining power

Trade unions are the group of employees with equal demand from employees. Bargaining power is the power that they hold to fight with their employees over the demand of the employees. If the unionization of labor is strong in a particular area then the wages of those employees is higher as the employers have the fear of losing the employees. Unionization plays a great role in describing the reason for the variation in wages (Amiti & Davis, 2012).

Compensating wage differentials 

Employees with higher skills are paid higher wages. Employees that undertake the risky jobs and complex tasks are paid higher wages in form of compensation and reward. If the contribution of the employees is high towards the revenue then get higher wages. This is the reason for the variation in wages. In a competitive labor market, it is the wages that compensates the opportunity cost that they have to incur that is in form of education or leisure activity.

The differences in wages depend on various factors such as social, ethical, political, economical, geographical and behavioral. The economic factors that affect the differences in wages are:

• Demand and supply of workers
• Bargaining power
• Cost of living
• Condition of product market
• Comparative wages
• Ability to pay
• Productivity of labor
• Job requirements
• Government policy
• And goodwill of the company (Van Kerm, 2013).

Conclusion

The above analysis shows that economics describes the reasons for the variation in wages using various economic theories such as minimum wage theory and wage differentials. Wage percentile is calculated in statistics, which in turn depends on the economic factors of wage differences. Wages depends on the skills, type of work, occupation, education and market in which they work.

References

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Bertoletti, P., & Etro, F. (2015). Monopolistic competition when income matters. The Economic Journal.

Ehrenberg, R. G., & Smith, R. S. (2016). Modern labor economics: Theory and public policy. Routledge.

Fujita, M., & Thisse, J. F. (2013). Economics of agglomeration: cities, industrial location, and globalization. Cambridge university press.

Gabszewicz, J. J., & Wauthy, X. Y. (2014). Vertical product differentiation and two-sided markets. Economics Letters, 123(1), 58-61.

Lane, J. I., Salmon, L. A., & Spletzer, J. R. (2013). Establishment wage differentials. BiblioGov.

Liu, Q., & Zhang, D. (2013). Dynamic pricing competition with strategic customers under vertical product differentiation. Management Science,59(1), 84-101.

Low Pay Commission. (2013). National Minimum Wage: Low Pay Commission Report 2013 (Vol. 8565). The Stationery Office.

Makadok, R., & Ross, D. G. (2013). Taking industry structuring seriously: A strategic perspective on product differentiation. Strategic Management Journal, 34(5), 509-532.

Makowski, L. (2014). Perfect Competition, the Profit Criterion, and the Organiza-tion of Economic Activity. Journal of Economic Theory, 22, 105-25.

Neumuller, S. (2015). Inter-industry wage differentials revisited: Wage volatility and the option value of mobility. Journal of Monetary Economics,76, 38-54.

Novshek, W. (2014). Equilibrium in simple spatial (or differentiated product) models. Noncooperative Approaches to the Theory of Perfect Competition,3, 199.

Roberts, K. (2014). The limit points of monopolistic competition.Noncooperative Approaches to the Theory of Perfect Competition, 3, 141.

Van Kerm, P. (2013). Generalized measures of wage differentials. Empirical Economics, 45(1), 465-482.

Zhelobodko, E., Kokovin, S., Parenti, M., & Thisse, J. F. (2012). Monopolistic competition: Beyond the constant elasticity of substitution.Econometrica, 80(6), 2765-2784.