Let’s imagine that you started a business and you have just earned yourself a tidy profit.
You feel that warm fuzzy glow inside you, and you know in that instant – you want it to last forever.
But how to?
Thankfully, you had studied Economics in JC, and even though it is highly theoretical as taught, it does prove to be a good starting point.
Economics can be en-riching (pun intended).
I often use imaginary case studies, such as above, to make my lessons interactive, and also show that Economics need not be a boring subject.
One of the most relevant section implicitly taught at “A” level, has to do with how firms grow and earn super-normal profits over the long term.
Put in more laymen terms, this is the same as: “how to make a killing in the long run“.
Before I go any further, I must point out that this article is highly simplified for students. If you are looking for a detailed market research reports, this wouldn’t be suitable for you!
But if you are a student, and you are thinking that this article isn’t relevant for you because starting a business is still a long way ahead, let me assure you that there are good reasons for you to read on.
Many of the following points are highly relevant to past “A” level questions including:
- Discuss whether the Law of Diminishing Marginal Returns is the main limiting factor to the size of a firm. (Students are expected to point out that expected revenue stream when expanding is a key factor as well)
- Discuss the effectiveness of the different strategies firms can employ in the face of rising competition. (This is obviously of direct relevance to the topic we will discuss here.)
So without further ado, let’s dive into the Economics of Earning Supernormal Profits Forever, and imagine ourselves to be the up-and-coming business owner.
Avoid entering a highly competitive market with low barriers to entry.
So you began initially by exploring business ideas. You eventually narrow your business ideas to a select few, and inevitably you will have to answer the most important question: How do I enter these markets?
Obviously some markets are easier to enter than others, thanks to differing barriers to entry.
Starting a small beverage stall at a hawker centre is a lot easier and within reach for many of us, than say, starting an oil drilling company.
To give some idea to that, a tiny deal needed to get your oil company going has to be worth at minimum a cool US$50,000,000. Yup, that’s 7 zeroes!
It’s easy then to see how such capital-intenstive industry tends to be monopolised by a single firm (Monopoly), if not a few very large ones (Oligopoly), due to the high barriers to entry.
If you can enter that sort of market and gain revenue traction, you can charge higher prices than if you had to contend with competitors who could undercut you. You can see this in the traditional diagram depicting a typical monopolist’s demand and supply in the market;
In theory then, the incumbents would be able to earn super-normal profits over the long-term because would-be competitors would be less able to enter the market.
But is this enough? Wouldn’t it be in your interest to keep the barriers insurmountable?
Keep your competitors out.
If you had entered the market before, it’s not hard to conclude that others can do the same eventually. To continue being part of a small group of firms in the market, you will need to actively keep potential competitors out.
While not quite as bloody as what we see on Animal Planet where the leader of a herd keeps competitors out, in most cases, the concept is very much similar.
A common tactic used by many incumbents is to engage in predatory pricing. Predatory Pricing refers to the act of lowering your price to a level below break-even price, with the aim of forcing competitors out of the market.
This is obviously a bruising tactic in which all firms in the market suffer. In some cases though, it can even be the new challenger who initiates such a campaign.
The story doesn’t end here though, incumbents often draw on other tools as well to maintain their position and associated super-normal profits. After all, why just stop here when more can be earned?
Differentiate yourself from your competitors.
As many of us know, differentiating your products from your competitors, be it objectively or subjectively, has the effect of making the demand for your products price inelastic.
In terms of profits, this means that assuming costs stay constant, you will be able to increase your profits by increasing the price of your product (per-unit price increases and also off-sets the less-than-proportionate decrease in quantity demanded).
There are various ways to differentiate yourself from your competitors. The most objective way to achieve this is to employ Product Differentiation. Good examples of this include airlines and their identities – you wouldn’t associate Airasia with top-of-the-world in-flight service, and yet they have done superbly well over the years.
Advertise and market your products.
Advertising is not all about merely raising awareness about your product and gaining sales traction. After all, if your competitors are alerted to the possibilities of gaining profits by entering the market, you won’t be doing yourself much favours.
Remember how I mentioned about Product Differentiation and how it helps cement your profits? It turns out that in many cases, it isn’t quite as objective as I had stated earlier.
It turns out that when it comes to advertisements, we really are easily swayed. What might be an ordinary run-of-the-mill product, may turn into a highly valued one, depending on the effectiveness of the advertising campaign.
One familiar manifestation is Brand Loyalty. We all have our quirky bias – in my case, I wouldn’t dream of switching away from Sony phones at the moment for no better reason than the fact that my irrational preferences.
There are those who say that Brand Loyalty is less applicable in today’s information age. But the point about the irrationality of human beings still stands.
If you could somehow create a following, you will have successfully differentiated yourself from the competition, thereby allowing you to raise prices, and revenue.
Reduce your average costs.
So far we have concentrated on generating additional revenue. But another way to improve your profit margins is to reduce your average costs.
For those who are not familiar with the concept of profit margins, it refers to the amount by which revenue from sales exceeds costs in a business.
As an example, a business that earns a 20% profit margin per unit sale, earns 20 cents in profit per dollar invested – this is actually a pretty good margin for many scenarios. Scale it up a thousand times, and you will earn a $200 profit for every $1000 you invest!
A highly relevant concept as far as lowering long-run average costs is that of Economies of Scale, which occurs when the average cost of producing falls as output increases. Expanding your business can lead to efficiency as you may not need to double your resources to double the output.
Similarly, increasing productivity of your resources can also lower your total cost for the same output, and improve your profit margins.
Cosy up to the regulator.
This is probably one of the “dirty secrets” to becoming rich (or richer if you already are). Obviously, this is a politically incorrect topic which isn’t covered in your Economics lessons.
Yes, you probably are familiar with corruption. Even squeaky clean Singapore has its share of cases here and there, the most recent being the ST Marine scandal, where ST Marine attempted to buy in to lucrative deals through bribery.
That’s one way to get rich (richer) fast (faster), and arguably the most recognised method.
But would it surprise you to know that many companies find less-obtrusive means to tilt the game to their favour? Of course not.
In many countries, China being a great example, state-sanctioned companies receive favourable deals and conditions that are lucrative. Banning Google in China leaves little credible competition for Baidu for example.
Even in democracies such as the USA, where you would expect less croynism and more “meritocratic” stories, powerful lobby groups created by companies with deep pockets continually hold sway over the government, leading to favourable game rules for themselves. The National Rifle Association is one well-known example.
Really, it’s all about your game-plan.
As you can see, there is a myriad of possible game-plans that different companies can take. You wouldn’t compare Airasia with Singapore Airlines. Nor would you do that between Charles & Keith and Louboutin shoes either.
In the end, running a profitable business is about finding the right opportunities, some luck, and a good game-plan using similar thought processes above (but obviously more advanced and with more realistic estimations).
Lend your support!
What are some other possible strategies to getting richer? If you know of any more, why not comment below, or share it with your friends?
To find out more about my services as a JC Economics tutor, visit my website here.