What this lesson teaches
I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.
Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms
Make a guess
A firm spends $2 million developing a new product. Will its profit rise?
- Yes. A new product brings in new buyers, so profit rises.
- Not for certain: the product may fail, or rivals may copy it.
- No. Research spending cuts profit, so firms should avoid it.
Show the answer
Not for certain: the product may fail, or rivals may copy it.
Innovation can raise demand or cut costs, but the spending comes first and the payoff is uncertain. Rivals may copy a success.
Innovation can lower costs or create new products, but it is costly and uncertain, and new technology can disrupt existing firms.
Process innovation finds cheaper or better ways of producing, such as automation. It lowers MC and AC, so a profit-maximising firm produces more and can charge less. If AC falls by more than the price, the gap between them widens and supernormal profit rises.
Product innovation creates new or improved products. Like differentiation, it shifts AR right and makes it less price elastic, so the firm can charge more and earn more supernormal profit until rivals catch up.
Research and development (R&D) is expensive and its results are uncertain. Firms with supernormal profit can afford it more easily.
Technological disruption happens when new technology makes existing firms' products or skills less valuable. Online shopping disrupted bookshops; streaming disrupted video rental. Disruption can bring in new competitors and push out firms that do not adapt.
- Process innovation
- Lower MC and AC.
- Product innovation
- New or better products.
- Disruption
- New technology makes old products or skills less valuable.
Worked example: Will new software pay for itself?
A printing firm can install software for $4,000. If it works well, it saves $600 a month for ten months. If not, it saves only $250 a month.
- Works well: savings of $6,000, a gain of $2,000.
- Works poorly: savings of $2,500, a loss of $1,500.
- The decision depends on how likely each outcome is.
- A trial or evidence from similar firms would reduce the risk.
Watch out for this
Innovation always raises profit.
Innovation costs money up front and may fail. Rivals may also copy it, so the gain may not last.
Check your understanding
A factory installs robots that cut the cost of each unit. What happens to its profit-maximising output?
- It stays the same; only profit changes.
- It rises, because MC falls.
- It falls, because fewer workers are needed.
Show the answer
It rises, because MC falls.
Right. Lower MC meets MR at a higher output.