Reasons firms invest in very competitive markets

Readers Question: Why invest capita in purely competitive industries with equilibrium margins that are razor thin and entrants that erode quasi profits? Suppose volume is not exceptionally large, why then?

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Economic theory suggests that firms will invest in industries where there is supernormal profit being made. Investment will be more attractive in industries where there is a degree of monopoly power and higher profit margins.

However, in the real world, firms can make decisions based on other factors and decide to enter an industry with low profit marigins.

Why might a firm invest in a very competitive market with low profit margins?

Self belief. An entrepreneur may have great self-belief that it can do better than all the incumbent firms. For example, the coffee shop market may be very competitive in a certain town, but someone with great passion for coffee may feel he can still do it better than all the incumbent firms. Therefore, even though the market is already competitive, they may still enter. This is something that economic theory may not give too much weight to – personal ambition, pride and self-belief – but it is a quite common that people think they can just be better than the competition. This self-belief may even be a motivation for a firm to enter a loss making industry.  It’s not quite the same, but recently restructuring specialist Hilco tookover HMV – a record shop making a loss. But, Hilco had the confidence to turn the firm around; initial reports suggest they have been successful.

Expand the market. An entrepreneur may see a very competitive market with low profit margin, but feel they can still expand the market. For example, in the 1990s, the coffee shop industry was probably quite competitive with a low profit margin. But, Starbucks still saw a gap in the market and opened a lot of new coffee shops (often right next to existing coffee shops). They felt they could grow the market, sell extras and increase profit margins. That industry has expanded and become more profitable in recent years.

Multinational companies can afford low profit margins. Many entrepreneurs would be reluctant to risk entering a market with very low profit margins. However, some big companies can afford to enter an industry even if they don’t expect to make much profit. For example, big supermarkets entered the petrol retail industry. They drove down already slim profit margins. Petrol retail is not there core business. They are probably happy for petrol to be a ‘loss leader’ to attract customers to the store. In other words, people come to fill up with petrol at Tesco, and then spend £80 to do their weekly shop. The profit on petrol maybe zero, but if Tesco gain more customers spending £80 on groceries it is a good business decision. It wouldn’t make sense for someone to set up an independent petrol station because profit margins are so poor (in fact many independent petrol retailers have closed down in recent years) There may be many other examples where multinationals feel there is strategic benefit to entering a competitive market with low profit margins.

Competitive markets may be a reflection of a good business model. A lot of firms may enter certain industries because it provides a steady and reliable business model. Rather than enter a risky or high tech industry, firms may prefer to stick to a safe business model. For example, selling nuclear power equipment is a high profit margin, low competition. But, you’re average entrepreneur doesn’t have the technical know how to start making nuclear products. However, it’s relatively easy to buy supplies from China and set up a Pound Shop. Entrepreneurs may prefer to enter a market with a strong business model which offers chance for reasonable returns without too much risk.

Profit is only one of many motivations. A limitation of micro theory is that it often assumes that it is simple profit maximising decisions which are important. However, people are moved by many other factors, such as growth maximising, working in an industry they see as important. For example, you could see blogging as a very competitive market. But, many bloggers will enter the industry – not to make profit – but to express their opinions and try and influence political debate. They may be content with very low profit margins.

The motivation is to make the product. A keen knitter may enter the home made teady bear market just because they like knitting. Low volume and low profit margins may be of no consequence to them.

 

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