Shelves full of bottled water for sale in supermarket: Charles Stirling (Travel)
Shelves full of bottled water for sale in a supermarket

Unit 7 The firm and its customers

How a profit-maximizing firm producing a differentiated product interacts with its customers

Before you start

To understand the price-setting model in this unit, you will need to be able to apply the method explained in Unit 3 for solving constrained choice problems using indifference curves and the feasible set. If you are not familiar with this method, you should read Sections 3.2 to 3.5 before beginning work on this unit.

7.1 Winning brands

In 1919, Jack Cohen was a street market trader in the East End of London. The traders would gather at dawn each day and, at a signal, race to their favourite stall site, known as a pitch. Cohen perfected the technique of throwing his cap to claim the most desirable pitch. In 1929, he opened his first Tesco grocery store, and later began opening supermarkets on the US model, adapting quickly to this new style of operation. Tesco became the UK market leader in 1995, and now employs almost half a million people in Europe and Asia.

market share
A firm’s proportion of the market in which its product is sold. It may be measured as its share of the total revenue in the market, or of the total quantity sold in the market.
profit, economic profit
A firm’s profit is its revenue minus its total costs. We often refer to profit as ‘economic profit’ to emphasise that costs include the opportunity cost of capital (which is not included in ‘accounting profit’).

‘Pile it high and sell it cheap’ was Jack Cohen’s motto. He started as a London street trader, and founded Tesco in 1929. Almost a century later, Tesco was the leading food retailer in the UK with a 25% market share, and the third largest in the world. Keeping the price low, as Cohen recommended, is one possible strategy for a firm seeking to maximize its profits: even though the profit on each item is small, the low price may attract so many customers that total profit is high.

profit margin
The difference between the price of a product and its marginal production cost.

Other firms adopt quite different strategies. Apple sets high prices for iPhones and iPads, increasing its profits by charging a price premium, rather than lowering prices to reach more customers. Apple’s profit per unit on iPhones is around 50% of the price, while Tesco’s profit margin is about 5%.

Many of the world’s best-known companies have succeeded by first anticipating what their customers want, and then establishing a recognizable brand with a reputation for quality. Lego, now the world’s largest toy maker, was founded in the 1930s by a Danish carpenter called Ole Kirk Kristiansen, who realised that toys children could build themselves would have more appeal than ready-made ones. Kristiansen cared deeply about quality, resisting his son’s efforts to cut costs. Ingvar Kamprad, the Swedish founder of the IKEA furniture company, wanted ‘to create a better everyday life for many people’, by offering good quality at prices they could afford. And according to Apple’s founder Steve Jobs, speed is also essential. ‘You can’t just ask customers what they want and then try to give that to them. By the time you get it built, they’ll want something new.’

These firms have been able to differentiate their product from those of their competitors: it has characteristics that customers value and believe they cannot find elsewhere. This unit shows how product differentiation gives firms a competitive advantage—the ability to control its own prices and generate economic rents. This is what the financier Warren Buffet has called ‘the moat’: something that separates the firm from its competitors and defends it against new entrants to the market. Lego, Ikea, and Apple were ahead of others in realising what would sell, but staying ahead required further innovation and product development, marketing, and efficient production and distribution. In 1962, Lego built an airport at Billund in Denmark to enable it to reach world markets.

A firm’s profit depends on more than getting the price right. Product range, attracting customers, and producing at lower cost and higher quality than competitors all matter. If a firm innovates successfully, it can earn economic rents—at least in the short term until others catch up.

Innovation can also help to keep costs low—IKEA’s flat-pack furniture reduces storage and transport costs. And cost advantages may come from growing big: for example, a large automobile manufacturer can produce at a lower cost per car.

For many businesses, labour accounts for a high share of costs, and some large companies, particularly in retail and fast food, have been able to profit from low wages and poor working conditions. Some have moved production to countries with lower wages or obtained labour from the gig economy. Other employers, particularly if they need specialized skills, use high wages and attractive working conditions to recruit, retain, and motivate employees.

To understand how different environmental regulations can affect firms’ decisions and their impact on the environment, read this Harvard Business Review article.

Firms also face costs from taxes and government regulations: for example, on employee safety and rights, environmental standards, product safety, and consumer protection. In protecting workers and consumers, regulation can help to create a level playing field where firms compete on the same terms, but firms can benefit from avoiding regulations or taxes, lobbying to reduce them, or relocating to countries with less stringent regulations.

Figure 7.1 summarizes key decisions that a firm makes. In this unit, we focus particularly on how a firm chooses the price of a product, and the quantity to produce. This will depend on the demand it faces—that is, the willingness of potential consumers to pay for its product—and its production costs.

This diagram shows how firms make decisions. The firm decides expenditure on innovation, which influences what to produce; expenditure on advertising; and expenditure to influence taxes and other public policies. These three types of expenditure influence the demand faced by the firm. Expenditure on innovation also influences how to produce, alongside the level of capital investment. In addition, the firm also decides the wage. How to produce; the wage; and expenditure to influence taxes and other public policies affect production costs. Once the firm knows the demand it faces and its production costs, it sets the price; then chooses the quantity; then hires the labour force. Finally, the firm can determine production, sales, and profit.

Figure 7.1 The firm’s decisions.