Explain how a profit-maximising firm sets its price and output decisions and why the firm might practice price discrimination.

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In the e-commerce market, firms like Amazon and Alibaba are facing growing competition due to the increasing ease of setting up online shops.

(a) Explain how a profit-maximising firm sets its price and output decisions and why the firm might practice price discrimination. [10]

Introduction

A profit-maximising firm makes its price and output decisions based on the marginalist principle, which focuses on the relationship between marginal cost (MC) and marginal revenue (MR). The firm’s primary objective is to maximise its profits, which occurs when the difference between total revenue and total costs is at its greatest. This profit-maximising condition is achieved where the firm's marginal cost equals its marginal revenue (MC = MR). I’ll explain how a firm sets its price and output decisions to maximise profits and why deviations from this condition—where MC is either greater than or less than MR—lead to suboptimal outcomes.

The Profit Maximisation Condition: MC = MR

For a profit-maximising firm, the optimal level of output is found where marginal cost equals marginal revenue (MC = MR). Marginal cost refers to the additional cost incurred when producing one more unit of output, while marginal revenue is the additional revenue gained from selling that extra unit of output. When a firm produces at the point where MC = MR, it ensures that the cost of producing the last unit of output is exactly equal to the revenue it generates from selling that unit. This is the level of output, denoted as Q₀, where profits are maximised, as any deviation from this point would result in either forgone profits or losses.

Why Not Produce Where MC > MR?

If a firm produces at a level where MC exceeds MR, denoted as Q₂, it means that the cost of producing an additional unit of output is higher than the revenue earned from selling that unit. At this level, the firm incurs a loss with every additional unit produced. For example, if the marginal cost of producing one more unit is $10, but the marginal revenue from selling it is only $7, the firm would lose $3 on that unit. This situation is clearly not profit-maximising because the firm could improve profitability by reducing its output. By cutting back on production, the firm can avoid these losses and move closer to the profit-maximising point where MC = MR. Thus, producing where MC > MR leads to a suboptimal outcome for the firm, as profits are not maximised.

Why Not Produce Where MC < MR?

Conversely, if a firm produces at a level where marginal revenue exceeds marginal cost, denoted as Q₁, the firm has an opportunity to increase profits by producing more. In this case, each additional unit of output contributes more to revenue than it costs to produce. For example, if the marginal cost of producing one more unit is $5, but the marginal revenue earned from selling it is $8, the firm would gain an additional $3 in profit from producing that unit. Therefore, the firm can increase its profitability by expanding output until it reaches the point where MC = MR. At this point, there are no further gains to be made from increasing production, as the cost of producing an additional unit would be exactly equal to the revenue it generates. Producing at any level below this would mean that the firm is not maximising its potential profits.

The Importance of MC = MR

The condition MC = MR is fundamental to the profit-maximisation objective because it represents the point where the firm’s profit is at its highest. At this level of output, denoted as Q₀, the firm is neither producing too little nor too much; it is operating at the most efficient level. If the firm were to increase output beyond this point, its costs would start to exceed its revenues, leading to a reduction in profits. On the other hand, if the firm produced less than this optimal level, it would be missing out on potential profits that could be gained by producing and selling additional units. Thus, only at the point where MC = MR does the firm achieve its profit-maximising level of output.

Why a firm may practice price discrimination

Third-degree price discrimination is primarily practised by firms to maximise profits by charging different prices to different consumer groups based on their varying price sensitivities, or price elasticities of demand. By doing so, firms can capture a larger share of consumer surplus— the difference between what consumers are willing to pay and what they actually pay— and convert it into additional revenue.

Golden Village, a popular cinema chain in Singapore, provides a clear example of this strategy. Golden Village charges different prices for the same movie experience depending on the demographic segment. For example, senior citizens and students are offered discounted tickets, while working adults pay the standard price. In this case, working adults tend to have more inelastic demand, as they often have higher disposable incomes and are less sensitive to price changes. Golden Village can therefore charge them higher prices without significantly reducing demand.

On the other hand, students and senior citizens typically have more elastic demand. They are more sensitive to price changes and would likely reduce their consumption of cinema tickets if prices were too high. By offering them a discount, Golden Village can still attract these groups to the cinema, ensuring they sell more tickets and fill more seats during showings that may otherwise not be at capacity.

In essence, by segmenting its market and charging different prices to groups based on their elasticity of demand, Golden Village maximises its overall profits. Each group is charged a price close to what they are willing to pay, allowing the cinema to capture more consumer surplus and thus increase revenue. This practice enables Golden Village to sell tickets to a broader audience while extracting the maximum possible revenue from each consumer group.