By Emil Jersling
Profit maximization for a Monopoly
Late 2008, with the financial crisis in full swing, I was discovering the magic of economic theory from the relatively safe environment of my INSEAD MBA classroom. A subject matter which had largely alluded me in spite of a fascination for mathematics, graduating a master of engineering, and business, launching my first startup and later working as a strategy consultant.
The mathematics were often trivial but the insights profound, like when Brett Saraniti, our charismatic and charming economics professor explained that a monopolist maximizes profit when marginal cost equals marginal revenue letting us calculate the profit maximizing price.
What are marginal costs and marginal revenues?
Marginal cost is the change in total cost arising from an increase in production quantity by one unit. Marginal revenue is the change in total revenue arising from the additional sale of one unit.
For example, assuming we need to increase production from 200 to 201. Marginal cost is the additional costs from purchasing additional supplies, equipment, or operating existing machinery with the associated electricity, wear and tear, and additional the labor cost to operate it.
Marginal revenue is often considered to fall as sales increase. Reasons for this include increased competition, market saturation, or new customers lower willingness to pay. Consider your willingness to pay for a haircut the day after visiting the barber. Most people’s willingness may be near zero after a fresh cut. I often advice entrepreneurs to start selling to the market segment with the highest willingness to pay. And if you are unable to sell to your most interested buyer you may need to reconsider your offering, or speak to Omar Najjar from Innovation Drive Sydney who rumor has it was able to sell a painting to a blind man.
“But I’m not a monopoly!” you say.
A monopoly is a firm that sells (nearly) all of the goods and services in a given market. Think Standard Oil Company during the late 19-century run by John D. Rockefeller or Microsoft’s dominance of the operating system market before 2000 for a more contemporary one.
As a judge at entrepreneurship competitions, I often came across participants claiming their product or service had no competition. This is almost always a sign of a poor market research or a poor understanding of the market. Quoting my marketing professor at INSEAD, Markus Christen, “A Porsche and a Mont Blanc pen, if serving the same purpose, are competitors”. Using this broader understanding of market and competition two products compete when serving the same purpose. Just like we now consider carbonated soft drinks and bottled water as competitors but before Pepsi started selling water in 1994 few might have held this view.
For my solution above to be true I’m assuming you are the exception and have a monopoly. Given how few truly new products come to market, how do you figure out your price, if the product does not meet an unmet need?
To implement competitive pricing try answering these 2 questions:
- What are your potential customers currently paying to serve the same need?
- What drives their purchase decision?
Consider pricing aggressively as customers must be persuaded to try your products over more familiar ones.
To implement value pricing ask yourself:
How much value do your customers perceive from this product or service?
As my old economics professor Brad explained. We all walk around appointing subconscious values for different products. You might be willing to spend up to $20 for a can of Coke if you are thirsty. Sales are only generated when willingness to spend > price provided the person is offered the opportunity.
Implementing customized pricing where you charge different prices to different customer groups allows you to maximize profit by targeting each segments individual willingness to pay. One example would be airline tickets where business travellers, vacation travellers and retirees price going from A to B are different.
If you want to learn more about strategies to figure out your price and price strategies. Check out this video from our 2020 cohort featuring some great mentors addressing this question. Also consider joining our next program, Shenzhen or Sydney Cohort 2022 to learn about this and much more!