How Companies Use Fundamental Economic Theories for Profit - Applied Economics

Though many discussions about economics surround big news, changing policies, and a broader scope of the financial health of a nation, economic theories are used on the smaller level of microeconomics as well, as explained in a previous article.

 

There are many different microeconomic ideas that companies use to maximize their profit and efficiency. This includes producing the most efficient amount, reducing waste, and reducing unnecessary costs. Many of these tools and concepts can be explained through a variety of graphs and curves.

 

First is the basic concept of producing what the market wants, or being allocatively efficient. When the government introduces quotas on imports, taxes, or price floors and ceilings, companies are no longer able to produce at the profit-maximizing quantity anymore. The waste, both from less possible profit and from the quantity produced, that comes from this is known as "Dead Weight Loss." Even without dealing with quotas or price ceilings and floors, companies need to pinpoint what quantity of production is the most profitable, so they use graphs and values such as marginal revenue, or the extra profit made from producing one more unit of output, marginal cost, or the true cost of producing one more unit, average total cost, or the average cost including fixed and variable costs of producing an additional unit of output, and more to determine how much they should produce.

 

Another economic concept that companies use is the concept of “Economies of Scale.” Think of it this way: when you make a batch of cookies, you need to preheat the oven, take out a tray, take out the flour, baking soda, chocolate chips, and other ingredients, preheat the oven for half an hour, and then bake the cookies – all if you wanted to make just one cookie. However, if you wanted to make five cookies, it would take the same half an hour of waiting to preheat the oven, the same tray, you would still have to take the time to take out the same can of baking soda, and more. The idea is that up to a certain point, producing more can result in more profit because mass producing is more efficient than going slow, or sometimes what the market wants at the time, as the average cost per unit produced decreases. Companies keep this in mind during production to reduce possible future costs and maximize efficiency. However, it is also important to note the idea of "Diseconomies of Scale," which is the opposite, in which there is a certain point in production that, when exceeded, the average cost per unit increases. For example, imagine you could fit ten cookies in the first tray, but the market wants twelve – buying one more tray for just two more cookies wouldn't be profitable even if the entire sale of the twelve cookies as a whole has profit, so production should be cut off at the original ten. 

 

Another takeaway is that different types of companies follow different economic rules. For example, a "Perfect Price-Discriminating Monopoly." These firms charge each customer the maximum amount they are willing to pay. For example, a car dealership negotiating individually with each customer. These firms can price-discriminate because they have the ability to separate customers by willingness to pay. On the other hand, “Non-Price-Discriminating Monopolies” follow a different rule. These firms are the only seller of their product, but they face the entire market demand curve. To determine their product price and level of output, looking at the graph for a Non-Price-Discriminating Monopoly, they produce where marginal revenue equals marginal cost, like every other type of firm (because this maximizes profit as it is the point where the revenue from selling one more unit exactly equals the cost of producing that unit, so producing more would lose money and producing less would leave money on the table), and from there they determine at what point the profit-maximizing quantity meets demand, in order to determine the price of their product.

 

Another type of economic tool that companies use is the idea of “Game Theory,” which looks at how competing firms make decisions when their profits depend on what the other firms do. Instead of just thinking about their own costs and revenues, each firm has to consider how competitors may react, for example, whether to change prices or production levels. This can be calculated using "Payoff Matrices," which are tables that list the possible choices of each firm and the profit that could result from each combination of choices. Businesses use this for pricing strategies, governments use it to design policies like trade negotiations, and even military planners use it to think about cooperation or conflict. Payoff matrices are especially used by “Oligopolies,” which is a company that produces in a market in which there are only a small number of firms competing, so each of those firms’ decisions affect the few others in the market.

 

The main takeaway here is to see microeconomics in action. Economics isn't just about the broad-scale implications of policies and decisions on the financial health of a nation; it can also be used on smaller scales, even down to the financial decisions of your favorite coffee shop down the block.