Question Pubudini Chathurika Finance & Economics

Product Differentiation and Profit Maximization

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. Discuss.

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Answer Internal Staff

Differentiation looks to make a product more attractive by contrasting its unique qualities with other competing products. Successful product differentiation creates a competitive advantage for the product’s seller. Certain (product) images may even allow for a higher selling price if the item is seen as highly desirable.

An assumption in classical economics is firms seek to maximize profits.

Profit = Total revenue – Total costs. Therefore, profit maximisation occurs at the biggest gap between Total revenue and Total costs. A firm can maximise profits if it produces at an output where Marginal revenue (MR) = Marginal cost (MC)

The condition that marginal revenue equals marginal cost is used to determine the profit maximizing level of output of every firm, regardless of the market structure in which the firm is operating.

With a monopoly, there is great to absolute product differentiation in the sense that there is no available substitute for a monopolized good.

Moving onto discussing monopolistic competition market, two of the characteristics of a monopolistically competitive market are consumers perceive that there are non-price differences among the competitor’s products and no business has total control over the market price (because there are many producers and many consumers in the market). However, these expenditures on product differentiation are not so great as to eliminate other goods as substitutes. If cross elasticities of demand between goods in a monopolistic market are high, then differentiation may not allow for a higher price point to be charged by the firm, and in turn, this (at least in the short run) will lead to losses as average total costs (from either changes in design or styling, unique advertising et cetera) exceed the price that the monopolist (as well as a competitive firm) can charge at the profit maximizing level of output.