Two firms, Alpha and Beta, are competing in a market in which consumer preferences are identical. Alpha offers a product whose benefit B is equal to $75 per unit. Alpha’s average cost C is equal to $60 per unit, while Beta’s average cost is equal to $50 per unit.
(a) Which firm’s product provides the greatest value-created?
(b) In an industry equilibrium in which the firms achieve consumer surplus parity, by what dollar amount will the profit margin, P 2 C, of the firm that creates the greatest amount of value exceed the profit margin of the firm that creates the smaller amount of value? Compare this amount to the difference between the value-created of each firm. What explains the relationship between the difference in profit margins and the difference in value-created between the two firms?
(a) To determine which firm's product provides the greatest value-created, we need to calculate the consumer surplus for each firm. Consumer surplus is the difference between the value that a consumer places on a product (in this case, $75) and the price they are willing to pay for it. For Alpha, the consumer surplus is $75 - $60 = $15 per unit. For Beta, the consumer surplus is $75 - $50 = $25 per unit. Therefore, Beta's product provides the greatest value-created since it has a higher consumer surplus per unit. (b) In an industry equilibrium where both firms achieve consumer surplus parity, each firm's profit margin will be equal to zero. This means that their price will be equal to their average cost. For Alpha, this means that they will charge $60 per unit, which is also their average cost. Therefore, their profit margin will be $75 - $60 = $15 per unit. For Beta, this means that they will charge $50 per unit, which is also their average cost. Therefore, their profit margin will be $75 - $50 = $25 per unit. The difference in profit margins between the two firms is $10 per unit ($25 - $15). The difference in value-created between the two firms is $10 per unit ($25 - $15). The relationship between the difference in profit margins and the difference in value-created can be explained by the concept of competitive advantage. Beta has a lower average cost than Alpha, which allows them to charge a lower price and still make a higher profit margin. This gives Beta a competitive advantage over Alpha, and allows them to create more value for consumers. As a result, Beta's product provides the greatest value-created in the market.
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