Should a firm quit while it's ahead?

Question

(2). A profit-maximizing firm expands its purchase of any input up to the point where diminishing returns have reduced the marginal revenue product so that it equals the input price. Why does it not pay the firm to "quit while it is ahead," buying so small a quantity of the input that the input's MRP remains greater than its price?

Answer 1

In theory, because it is trying to maximize profit, not maximize margin. Up until the point where marginal cost = marginal revenue, every additional unit increases profit.

In practice there are other reasons for trying to grow, even beyond the theoretically ideal size:

1. The larger a firm is, the greater its market clout. No firm wants to be in a situation of perfect competition. Every firm strives to be a monopoly, or at least an oligopoly, so it can make greater profits. That means squeezing the competition out, one way or another.

2. The larger a firm, the more it can devote to change: developing new products, etc. Very few companies produce one and only one product forever and ever. Classical theory assumes the world is static. Reality is different.

3. Managers are people: they like managing a bigger company rather than a smaller one, more people rather than fewer.

On the other side, there have been companies who have  "quit while they were ahead". For example, polyethelene production started out as a big money maker for the major American petrochemical companies - they had a tremendous advantage in technology and hence cost over everyone else. But over time, other companies all over the world built newer factories with newer technology and made the polyethylene market more competitive. The American companies decided it wasn't profitable enough to be in such a competitive market and sold their factories.

Or consider General Electric under Jack Welch. At the time, GE was a major conglomerate. His approach was to sell off every division that was not either #1 or #2 in its industry.

http://en.wikipedia.org/wiki/Jack_Welch