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
Expanding would cut a firm's average cost by 20%. Should it expand?
- No. Expanding is always too risky for a firm.
- Only if it can sell the extra output profitably.
- Yes. Lower average cost always means more profit.
Show the answer
Only if it can sell the extra output profitably.
Lower average cost helps only if the extra output sells. If the firm must cut its price sharply, profit can fall.
Expand only if the extra revenue is likely to exceed the extra cost, allowing for the risk that demand disappoints.
Expanding can lower average cost through economies of scale, but the firm must still sell the extra output.
To sell more, it may need to cut its price, which reduces revenue on every unit.
So compare profit before and after, using realistic sales estimates and allowing for things going worse than planned.
A useful approach is to find the break-even sales level: how many units must be sold for expansion to be at least as profitable as staying the same size.
- Test
- Compare profit before and after expanding.
- Risk
- Plan for weaker demand than expected.
Worked example: How many sales justify expanding?
A producer now sells 100 units a month at $25, with total costs of $2,000. Expanding would cost $3,000 a month in total, and all units would sell at $20.
- Now: profit = $2,500 - $2,000 = $500.
- Expand and sell 200: profit = $4,000 - $3,000 = $1,000.
- Expand and sell only 150: profit = $3,000 - $3,000 = $0.
- To match today's $500 profit, it must sell 175 units ($3,500 - $3,000). Expand only if it is confident of selling well above 175.
Watch out for this
Lower average cost always means expanding is a good idea.
The firm must also sell the output. If demand is weaker than expected, profit can fall even with lower average costs.
Check your understanding
After expanding, a firm's average cost falls from $8 to $6. It sells 1,500 units instead of 1,000, but only by cutting its price from $10 to $7. What happens to its profit?
- It rises from $2,000 to $3,000, because sales grow by half.
- It stays at $2,000, because the cost cut and price cut cancel out.
- It falls from $2,000 to $1,500, as each unit now earns $1.
Show the answer
It falls from $2,000 to $1,500, as each unit now earns $1.
Right. Before: ($10 - $8) x 1,000 = $2,000. After: ($7 - $6) x 1,500 = $1,500. The price cut outweighs the cost saving.