Study Notes on Dynamic Analysis of Firm Strategy and Economic Profit

Strategies for Creating and Sustaining Economic Profit

• Central Objective: Firms seek methods to move from a state of normal profit to economic profit and, crucially, to sustain that profit over time.
• Method 1: Cost-Advantage Strategies: Aimed at lowering the cost structure of the firm.     * Fixed Costs Only: If only fixed costs are reduced, the Average Total Cost ($ATC$) curve shifts downward. Marginal Cost ($MC$) and Average Variable Cost ($AVC$) remain unchanged.     * Variable Costs: If variable costs are reduced, the $ATC$, $AVC$, and $MC$ curves all shift downward.
• Method 2: Increasing the Number of Consumers: This involves growing the total customer base, which physically shifts the Demand curve ($D$) to the right.
• Method 3: Increasing Real or Perceived Value: This involves strategic product differentiation, positioning, and building brand loyalty.     * Graphical Impact: Shifts the Demand curve ($D$) upward (representing a higher willingness to pay) and makes the curve less elastic (steeper).
• Method 4: Deterring Potential Competitors: This refers to the strategic barriers or actions taken to prevent other firms from entering the market, which is the only way a firm can hold onto economic profit in the long run.
• Baseline Assumptions for Model Analysis:     * Demand is downward sloping, indicating the firm possesses some degree of market power.     * The starting point assumes only normal profit (zero economic profit), where $P = ATC$.     * This initial state is consistent with the long-run steady-state for a monopolistically competitive firm.

Dynamic Analysis of Product Differentiation and Advertising

• Strategic Goal: Engage in promotion and differentiation to increase the perceived Marginal Benefit ($MB$) for consumers and decrease the price elasticity of demand (increasing loyalty).
• Stage 1: The Immediate Effect of Advertising:     * Classification of Cost: Advertising is treated as a Fixed Cost ($FC$), not a variable cost. It does not change based on the quantity ($q$) produced.     * Cost Shift: Because it is a fixed cost, the $ATC$ shifts upward (from $ATC_0$ to $ATC_1$). The $MC$ curve does not move because $AVC$ is unchanged.     * Equilibrium: Since neither $MR$ nor $MC$ has moved yet, the profit-maximizing quantity remains at the original $q^<em>_0$.      Result: At $q^*_0$, the new $ATC_1$ is higher than the price ($P_0$). Consequently, the firm initially incurs an economic loss.
• Stage 2: Effects of a Successful Campaign:     * Demand Shift: Demand ($D$) moves upward (due to higher willingness to pay) and to the right (due to an increase in the number of customers).     * Elasticity: The Demand curve becomes less elastic (steeper).     * Revenue Shift: The Marginal Revenue curve shifts from $MR_0$ to $MR_1$.     * New Equilibrium: The firm identifies the new intersection where $MR_1 = MC_0$. This results in a higher quantity ($q^<em>_1$).      Profit Outcome: The new price ($P_1$) is now higher than the new Average Total Cost ($ATC_2$). Because P > ATC, the firm generates an economic profit.
• Critical Evaluations and Risks:     * Failure Risk: What happens if the advertising campaign is not successful? The firm is left with the higher $ATC$ from Stage 1 without the corresponding shift in Demand/Revenue, leading to sustained losses.     * Sustainability: Since profit acts as an incentive for competitors to enter the market, the duration of this profit depends on the height of barriers to entry and the extent to which competitors can replicate the success.

Dynamic Analysis of Cost Advantage Strategies

• Short-Run Impact of Lowering Production Costs:     * Scenario Assumption: The strategy successfully lowers Average Variable Costs ($AVC$).     * Cost Shift: A decrease in $AVC$ causes both the Average Total Cost ($ATC$) and Marginal Cost ($MC$) curves to shift downward (to $ATC_1$ and $MC_1$).     * Note on Fixed Costs: If only fixed costs were lowered, $ATC$ would fall, but $MC$ and $AVC$ would remain stationary.     * Revenue Dynamics: Initially, the Marginal Revenue ($MR$) curve does not move.     * Optimizing Quantity: Because $MC$ has shifted down, the new intersection of $MR = MC$ occurs at a higher quantity level ($q^*_1$).
• Price and Profit Realization:     * Price Adjustment: Following the Law of Demand, to sell the now-higher quantity ($q^<em>_1$), the firm must decrease its price ($P_1 < P_0$).      Profitability Requirement: Although the price falls, a profit is realized if the $ATC$ falls by a greater magnitude than the price decrease.
• Long-Run Considerations:     * The primary question for management is historical: "How long does this last?"     * Economic profit serves as a signal and incentive for external competitors to enter the industry.     * The long-term outcome is entirely dependent on barriers to entry that prevent competitors from adopting the same cost-saving technologies or processes.