If the numerator equals the denominator, |€| = 1, and demand is unit elastic. When demand is unit elastic, quantity demanded changes proportionately to the change in price. Price Elasticity of Demand and Total Revenue Total revenue of a seller equals price times the quantity sold: Total Revenue = x Quantity. If demand is price elastic, %AQ4 > 96AP. Hence, when demand is price elastic, an increase in price leads to a decrease in total revenue: tPrice> {Total Revenue. Conversely, when demand is price elastic, a decrease in price leads to an increase in total revenue: |Price > {Total Revenue, If demand is price inelastic, 6AQg < %AP. Hence, when demand is price inelastic, an increase in price leads to an increase in total revenue: Price > Total Revenue. Conversely, when demand is price inelastic, a decrease in price leads to a decrease in total revenue: {Price > {Total Revenue. If demand is unit elastic, %4Q4 = % AP. Hence, when demand is unit elastic, a change in price leads to no change in total revenue. Demand Curve, Marginal Revenue Curve, and Price Elasticity of Demand Suppose that a price-setting firm initially sells 10 units at P8 each. As Figure 6.2 shows, because it faces a downward-sloping demand curve, to sell 15 units of its product, the firm must necessarily lower the price to P7 each. Price (pesos per unit) Revenue lost 98-7x10=F10 Revenue gained 7x5 = 35 10 15 2 ©6900 aq |= (Quantity (units per week) Suppose that the firm sells every unit at the same price. That means the firm is choosing between selling 10 units for ®8 each or 15 units for P7 each. Figure 6.2 Effects ofa Price Reduction on Total Revenue To increase the numberof units sold from 10 units to75 Units, the fiem with market power must recce price from #8 107 per Unit. The gain in revenve due to the aditional 5 units sold ‘equal area 8, The revenue lost fn the 10 units It used to sell at the higher price is equal 0 area ‘A-Ths the change in total reve- ‘ve equals atea 8 area A (Cunt MARKET POWER ELASTICITY ANDPRENGDECHIONS 25Figure 6.3 Demand Curve and ‘Marginal Revenue Cure Fora frm with market power, ‘the demand cure les above the marginal revenue cure for any ‘quantity greater than 0. For a straight ine demand curve, the ‘marginal revenue cure cuts the horizontal axis halfway between the origin and the point where the demand curve cuts the hor- zontal ais “The firm in our example both gains and loses by lowering price. The firm gains £35 (P7 x 5 = P35), the revenue from the additional five units sold, because price was lowered. It loses * 10 [(P8 — #7) x 10 = P10]; it loses 1 on each of the 10 units it used to sell at P8 each, The firms net gain from selling the additional five units of output is P25 (P35 - #10 = 25). Demand Curve and Marginal Revenue Curve ‘Imagine that a firm decreases the price. This firm's marginal revenue is the change in total revenue that results from selling one additional unit of output: wee 2 4Q ‘The change in total revenue, ATR, that results from a decrease in price has two parts: First, the revenue the firm gains from the additional units sold, PAQ. Second, the revenue the firm loses on each of the units it used to sell at highe price, QAP, which is negative since AP is negative OTR PAQ+QAP (aP) This yin! SY Se pg Crea ag Prog) Since AP is negative, Q(AP/AQ) < 0 and MR < P.That is, for any quantity greater than 0, the marginal revenue is less than the price the firm can charge to sell that quantity. Note that when Q = 0, marginal revenue equals the price. This is shown in Figure 6.3. Price (pesos per unit) 10 Marginal revenue curve Quantity (units per week) 50“al Figure 6.3 shows that marginal revenue can either be positive or negative. The = greater the quantity, the more likely that marginal revenue will be negative. The cee reason is that the greater the quantity, the more likely that the revenue the firm gains from the additional units sold is more than offset by the revenue the firm loses on each of the units it used to sell at a higher price. “The figure illustrates the relationship between the firms demand curve and F marginal revenue curve. The demand curve plots price, P, and quantity, Qi the ‘marginal revenue curve plots marginal revenue, MR, and quantity, Q. Because, for any quantity greater than 0, price is greater than marginal revenue for the firm, its demand curve lies above its marginal revenue curve for any quantity greater than 0. — Marginal Revenue and Price Elasticity of Demand | ‘We can restate the equation for marginal revenue and write marginal revenue in terms of the price elasticity of demand. sigher MR = P + Q(aP/4Q) Factoring P out in the above equation for marginal revenue gives us MR = P[1 + QP (AP/AQ)I. ae “To express marginal revenue in terms of the price elasticity of demand, we should i. note first that the price elasticity of demand is given by the formula = € = %AQd = AYQ = P OO 96 0P ‘aP/P Q oP ! “Thus, the term Q/P (AP/AQ) in the marginal revenue equation is equal to 1/€, thats, the reciprocal ofthe price elasticity of demand. Making this substitution gives us MR=P (1+ 1/€) Now recall that economists usually simplify things by using the absolute value of the elasticity coefficient. Thus, the marginal revenue equation is usually given by MR = P(1~ “ep ‘This equation reveals an important set of relationships between marginal revenue and price elasticity of demand: ‘When demand is price elastic, |€| >1,MR > 0. "The firm can increase total revenue by lowering price, increasing quantity produced and sold. When demand is price inelastic, |€| < 1, MR < 0.The firm can increase total revenue by raising price, reducing quantity produced and sold. When demand is unit elastic, |E| = 1, MR = 0. The firms total revenue will not change when price and quantity are changed by a small amount. , “This set of relationships between marginal revenue and price elasticity of demand is shown in Figure 6.4 on the next page. hte 6 = MARKETPOMER ELASTICIT ANDPREMGDECSIONS. 6Figure 64 Marginal Reverwe Price (pes0s per unit) and Pree Elastity of Demand The follwing set of relationships between mero evenve and price elastity of demand applies 8 {oa near demand curve. Where ‘demand is price este, marginal 10 Elastic (El < 1) ferenel pose, Where de Unit elastic | ‘mands price inelastic, marginal } revenue is negative. Where (el=1) demand i unit elastic, marginal oe oe o@ Inelastic (161 > 1) Quantity ; (units per week) MR Inelastic Region of the Demand Curve AA firm could choose to set its price anywhere along the demand curve facing it. But a profit-maximizing firm with market power will not want to operate on the price inelastic region of the demand curve (i. illustrates why this isthe case. Ifa price setter is operating at a point at which demand is inelastic, the frm could always increase profit by raising its price, reducing quantity produced, and moving towards the price elastic region of the demand curve (.., the region in which |E| >1). When a price-setting firm moves from a price inelastic region to the price elastic region, total revenue goes up, and total costs go down because the firm is producing less. If total revenue rises and total costs fll, profit goes up. Thus, at any point on the inelastic region of the demand curve facing the firm, the firm can raise its price and find a point on the elastic region that offers it a higher profit. The Optimal Markup Rule Let us review some of the ideas we have discussed so far. We learned that changes in quantity of output produced lead to changes in both total revenue and total cost. ‘Changes in total revenue and total cost lead to changes in profit. We have a measure of how much total revenue changes if one additional unit of output is sold—called marginal revenue. We also have a measure of how much total cost changes if one additional unit of output is produced and sold—called marginal cost. Change in price >» Change in quantity produced and sold —> Change in marginal revenue and change in marginal cost -> Change in profit ., the region in which |€| <1). Figure 6.4 88. Apotindconomes‘The combination of price and quantity that yields the highest profit is the combination at which the marginal revenue (MR) equals the marginal cost (MC). Figure 6.5 illustrates the profit-maximization condition MR = MC for the firm with market power. The marginal revenue curve MR lies below the demand curve for all output levels greater than zero. Price (pesos per unt) ue a o Quantity ¢ o (units per week) Figure 6.5 shows that at the profit-maximizing price P* and quantity Q’, MR=MC. ‘The equation that expresses marginal revenue in terms of price elasticity of demand, MR = P (1 ~ 1/|€]), provides us another way to express the firm's profit- maximization condition MR = MC: P(1=1/fe) = MC Rearranging this expression algebraically and letting P* stand for the profit- ‘maximizing price and MC* stand for the marginal cost associated with the profit~ maximizing quantity, Q*, gives us ProMCt = 1 lel e ‘The equation above is called the optimal markup rule. The optimal markup is the ‘markup which yields the highest profit—the markup at which the marginal revenue equals the marginal cost. The optimal markup rule states that the firms optimal ‘markup of price above marginal cost, expressed as a percentage of price is equal to the inverse of the absolute value of the price elasticity of demand coefficient. Figure 6.5 The Profitnarimiza- tion Condition The proitemaximizing output is (*, were MR = MC. To sell that uiput, the frm with market ower willseta price of haper6 = MAMET POWER ASTI ANO PRG DECSIONS 89‘The optimal markup rule tells us that the price elasticity of demand plays a critical role in determining the extent to which the firm with market power can raise price above marginal cost. Specifically, it says that the less price elastic | the firm’s demand, the larger will be the optimal markup. Figure 6.6 shows this relationship between the firm's optimal markup of price over marginal cost and the price elasticity of demand. Figure 6.6 Price Elasticty of Demand and Price Markup ‘The demand in panel (b's relatively less price elastic than the demand in panel (a). The difference between the prof itmaximizing price, P, andthe marginal cost, MC*, is larger ‘when demand is relatively less price elastic. n pane), the ‘ptimal markup is higher and the fim has more market power. Quantity In Figure 6.6, the demand in pane! (a) is relatively more price elastic than the demand in panel (b). The optimal markup is smaller in panel (a) where demand is } relatively more price elastic. ‘We can use the optimal markup rule to reach the conclusion that a profit- maximizing firm with market power always produces on the elastic region of the demand curve fi To sce why this is the case, we start with the fact that marginal cost is positive. This implies that the marginal revenue at the profit-maximizing level of output must also be positive. But the only way marginal revenue can be positive is ifthe term (1 - 1/(€|) in the marginal revenue equation is also positive. The term (1 = 1/[€|) is positive if [¢| >1, that is, if demand is price elastic. Lerner Index of Market Power Because firms with no market power will,in general, charge prices that equal marginal cost while firms with market power generally charge prices that exceed marginal cost, economist Abba Lerner suggested a measure of market power: the percentage ‘markup of price over marginal cost, (P - MC)/P. This measure is now called the Lerner Index of market power. It ranges from 0 to 1 (or from 0 to 100 percent). It is zero for an industry in which firms have no market power. It is positive for any industry in which firms have some degree of market power. Market Structure and Market Power ‘Market power is determined by the structure of the market in which a firm operates. ‘A market structure is a set of market characteristics that influence the firm's pricing and output decisions: (1) the number of firms competing in the market, (2) the degree to which firms are able to differentiate their products, and (3) the ease by which new firms enter the market.Perfectly Competitive Market Ina perfectly competitive market, there are many firms competing in the market, cach selling a product that is indistinguishable from all other firms' products. Because a perfectly competitive firm is selling a product that is identical to other products in the market, the demand for the firms product will be infinitely elastic: |€| = =. the firm tries to set the price for its product above the going market price, the quantity demanded falls to zero. It follows that a perfectly competitive firm faces a demand curve that is a horizontal ine at the market price, as shown in Figure 6.7, panel (a). Price 2. Price = Marginal Revenue 0 ‘Quantity (@) Price Mo Price = Marginal Revenue | ° o ee “The market demand curve in a perfectly competitive market is downward sloping in the usual way. But because the output ofa single firm is small relative to the whole ‘market, each firm can sell as much as it wants at the going market price; thus, each firm is facing a demand curve that is horizontal at the market price. Because a perfectly competitive firm produces at the point where price equals marginal cost, as shown in panel (b) of Figure 6.7, a perfectly competitive firm does not have market power. The firm's optimal markup of price above marginal cost ‘equals zero. Tn general a firm that sells a product that is very similar to other products in the market faces a demand that is highly price elastic. If that firm increases its price even a litle the demand for its product will decrease by a large amount. Figure 6.7 Demand Curve Faced bya Perfectly Competitive Fim ‘A firm with no market power faces a horizontal demand curve, as shown in pane! ()- Panel (0) Shows that, fra firm with 00 ‘market power, profits max mized at Q, the leve! of output ‘at which P= MC. Did You Get tt? G1 Explain why marginal revenve is less than the pice when a fm faces a downwardsloping demand curve. Explain why marginal revenue equals price ‘when a frm faces a hovizoeta demand curve Chater 6 = MARKET POWER ELASTICITY AND PREG DECHIONS 91Did You Get 35] No market is truly perfectly competitive where there are many sellers of goods ‘What Wanjthing do al fra that are absolutely identical. Many analysts consider the markets for agricultural ‘operating in dlfferent_matket commodities as close to being perfectly competitive. For example, there are thousands seen eee of rice farmers, each small relative to the whole market, and each rice farmer produces rice that is very similar to the rice produced by other farmers. It is important to note ‘however that a seller in the local rice market can have some degree of market power if itis located more conveniently for some consumers. Economics in Action * REFERENCES: : Roberts, Russell. “Where Do The Philippine Rice Market ces come om tv. In the Philippines, there isan ongoing debate onthe extent of market power Y2o07msersprees nim sela | of some participants in the local rice market. Newspaper reports have blamed rere sale “conpestor.n | opportunistic rice trades forthe eratie movernent of ce prices, Some analysts Sra fopid Apprasa” PDs Poy | élsagree with ths view. Notes No. 2014-10(May 2014), ] Economists settle disputes like this by understanding the theory behind the ‘opposing sides of the argument and then using past experiences with price increases, along with the tools of statistical and economic analysis, to estimate the magnitude of the price elasticity of demand and some measures of market power. 100 you think some participants in the local rce market have some market power? if 50, which participants have some market power and how is that market power } reflected in prices? In thinking about the extent of market power of some participants inthe local ice market, itis important to note that many people tend to think that sellers set prices by whim or impulse, without regard for the preferences of consumers or the action of other sellers. But anyone who has tried to sell anything knows that no seller can set price by whim or impulse. A rice seller will quickly find out that fhe sets a price : that is much higher than the price set by other sellers, he won't be able to sell ice. Sellers understand that their rice is in competition with other rice available in the market. Rice prices normally tse after a typhoon destroys some of the country’s prime rice growing land. That might lead one into thinking that rie sellers engage in “price gouging” raising prices ata time of crisis. But the real reason the average rice buyer has to pay more after a typhoon could have nothing to do with price gouging and. could have everything to do with the alternatives ofthe average rice buyer after the typhoon compared tothe alternatives before the typhoon. Rice buyers do not pay @ higher price uniss they have to. When they have lower- priced alternatives, they do not have to. When a typhoon diminishes the availability of lower-priced alternatives, buyers have to pay a higher price for what s available. Rice is more costly to provide after a typhoon. It continues to be avaiable in the ‘market after a typhoon because many people want to buy it: But for sellers to be willing to provide it, it has to sell fora higher price. 82 ppp enemiesimperfectly Competitive Market In an imperfectly competitive market, firms face downward-sloping demand curves, Imperfectly competitive firms possess some degree of market power and can raise price without losing all of their customers to competitors. In the case of monopoly, only one firm serves a market and there are barriers to the entry of new firms. Examples of monopoly include local public utilities such as clectricity and water. The demand curve faced by the single seller—monopoly firm or ‘monopolist—is the market demand curve. The magnitude of market power depends entirely on the price elasticity of market demand—the less price elastic the market demand, the greater the degree of market power the monopolist will have. The price elasticity of market demand faced by a monopolist depends on how easy it is for consumers to find substitutes for the product sold by the monopolist. If there are no close substitutes for its product outside its industry, the monopolist will face a relatively less elastic demand curve and have a high degree of market power. ‘What keeps a real-world monopolist from setting outrageously high prices despite having the market to itself? A sole provider of landline telephone services faces indirect competition from outside its industry—that is, from the sellers of cellular phones. If there are products that are close substitutes for the monopolist’s product, demand for the monopolist’s product is likely to be relatively more price elastic, and the monopolist will not be able to translate its market power into a large markup of price over marginal cost. Inamonopolistically competitive market, 2 large number of relatively small firms produces and sells slightly differentiated products. There are no barriers to the entry of new firms. New firms usually produce and sell products that are close substitutes to the product of existing firms but not exactly the same product as the existing firms sell. Examples of monopolistically competitive market include the market for soft drinks, bottled drinking water, and retail clothing. ‘Market power depends on the price elasticity of demand facing the firm. Although market demand for bottled drinking water could be inelastic, several suppliers serve the market. Hence no single bottled water seller can raise its price significantly Beet Ww ee pss 5 Did You Get It? (5) Suppose that your city er town jrants one pizza supplier 2 legal ‘monopoly on preducing and delivering plazas’ all other pza roducers were ordered to ext the ‘market. What wil happen to the local market fr pizzas? ‘A sll of landline telephone Services faces indirect compe: tition fom sellers of mobile haste 6 + MARKET POWER LASTICY, AMO PRLENG DEON 93Did You Get It? 2 perfectly competitive frm need notmake any effort tofind another ‘Customer while s monopolitically Competitive firm s always eagerto {getanother customer. Why? Did You Get te? 5 What makes oligopoly. pricing decisions difcult to analyze? REFERENCE: ‘Agcaoli, Lawrence. “Cebu Paci Tigerar plan to rase fares." Plip- ‘ine Star, February 13, 2014. without losing customers to other sellers because consumers can easily substitute one bottled drinking water for another. As a result, the demand for any one bottled drinking water is often more elastic than the demand for the entire market. ‘The price elasticity of demand facing 2 monopolistically competitive firm depends on the uniqueness of the firm's product. The more successful the firm is in differentiating its product in the minds of buyers or in establishing a well-respected brand name, the less price elastic will be the demand for the firms product In an oligopoly, a small number of firms compete in the market and each firm considers how the other firms will respond to its actions. Firms produce either identical or differentiated products and the bartiers to the entry of new firms are significant. Examples of oligopoly firm include airline and shipping companies. ‘When there are only a few firms competing in the market, market power depends ‘on the price elasticity of demand facing the firm which in turn depends on how aggressively they compete with each other. When firms are competing aggressively, they undercut each other's prices to capture market share. The more aggressively firms compete with each other, the more ‘each firm will fear that it would lose market share if it raises its price. On the other hand, the firms might not compete with each other and might even have a collusive agreement to restrict output and raise price.1In «general, the less aggressively oligopoly firms compete with each other and the more they are able to collude successfully to keep the price high, the more market power cach firm will have. Economics in Action * The Market for Air Transport Services 1n.2014, Cebu Pacific and then newly acquired Tgerair Philippines filed petition before the Civil Aeronautics Board to raise fares for both international and domestic routes. Do airlines—companies that provide air transport services—have some market power? if so, how is that market power reflected in prices? ‘Competition for profits affects price in an industry with a few producers—a situation “termed oligopoly. Consider the pricing problem of Cebu Pacific. Pilippine Airlines san “important competitor thus neither Cebu Pacifcnor Philippine Aiineshasa monopoly ‘of the Philippine market. And Cebu Pacific and Philippine Airlines are not perfectly: “competitive firms. This means that if Cebu Pacific raised its price, it would not lose all its customers to Philippine Airlines, and if it lowered its price, it would not steal all of "Philippine Airlines’ customers. In other words, the two airlines are able to differentiate “thelr services. Cebu Pacific provides services that are close but not perfect substitutes to the services provided by the other airlines. The more successful Cebu Pacifici In differentiating its product in the minds of buyers or in establishing a well-respected brand name, the less price elastic will be the demand for the airline's services and the ‘greater its ability to mark up price above marginal cost. Strategic behavior occurs in such a situation because each airline has to take into ‘account the response of other ailines to its own actions. The extent to which Cebu Pacific would raise or lower fares for domestic or international routes depends on its “assessment about how other airlines will react to whatever course of action it takes. :Conclusion * This textbook directs your attention to personal and business decisions that matter in your everyday life and in your future careers. In this chapter, we have set out the ‘concepts and principles that would help you understand how business people decide ‘on what prices to set on the products they are selling. It is not hard to understand why business people pay so much attention to market researches and statistical studies that provide them some knowledge concerning price elasticities of demand for their products. Knowledge of these price elasticities is ‘essential to pricing decisions, and pricing decisions have immediate impact on profits, ‘The optimal markup rule tells us that the firm has more power to mark up its price above marginal cost when it faces a less elastic demand for its product. The optimal ‘markup rule presumes that the goal of the firm is to make as much profit as possible, In practice, owners and managers of business firms often use rules of thumb that may not be substantially based on the price elasticity of demand, Nonetheless, there is a {900d reason to think that pricing decisions of business firms do not stray too far from ‘the optimal markup rule. firm that routinely strays too far from the profit-maximizing prices will make less money than its competitors and is more likely to be forced out of business and replaced by another firm that pays more attention to price elasticities. Key Points |. Market power is the ability of market par- 5. The optimal markup rule tells us that the ticipants—sellers and buyers—to affect firm has more power to matk up its price the price of a good or service. This chap- above marginal cost when it faces a rela ter focuses on the ability of the sellers to tively less price elastic demand. affect the price of a good or service that 6. Amarket structure is a set of market char- they are selling. acteristics that influence the firm’ pricing 2. Firms that have matket power are some- and output decisions. Market power is de- times referred to as “price setters" while termined by the structure of the market firms that have no market power are In which a firm operates: the number of sometimes referred to as “price takers! firms competing in the market; the degree 3. When a firm charges a price that is above to which firms are able to differentiate ‘marginal cost, we say that it has market their products;and the ease by which new power. Economists measure that mar firms enter the market. ket power by the extent to which price 7. As the number of firms competing in a exceeds marginal cost. The Lerner Index __market increases, the demand elasticity of market power is a measure of market facing each firm rises because consumers ower: markup of price above marginal have more choices. The number of firms ost, expressed as a percentage of price. competing in a market is determined by 4. Price elasticity of demand isa measure of how easy itis for new firms to enter the the responsiveness of quantity demand- industry. fed to changes in price. The more price 8. A firm that sells a product that is very sim- elastic demand is, the more responsive is___ lar to the products sold by many other quantity demanded to changes in price. firms in the market faces a demand that is hp» MARAT POWER, ELASTICITY, AND PREMG DECSIONS 95highly price elastic. If that firm increases its price even a litle, the quantity de- manded of its product will decrease sig- nificantly. 9, Because a perfectly competitive firm is selling a product that is absolutely iden- tical to other products in the market, the demand for the firm's product is infinite- ly elastic. A perfectly competitive firm hhas no market power. 10.In the case of monopoly, only one firm serves a market and there are barriers to the entry of new firms. If there are no close substitutes for its product outside its industry, the monopolist will face @ relatively less elastic demand curve and 11.Ina monopolistically competitive market, a large number of relatively small firms produces and sells slightly differentiated products. The more successful a monop- olistically competitive market firm is in differentiating its product in the minds of buyers or in establishing a well-respected brand name, the less price elastic will be the demand for the firm's product. 12.In an oligopoly, a small number of firms compete in the market and each firm con- siders how the other firms will spond to its actions. The less aggressively oligopo- ly firms compete with each other and the more they are able to collude successfully to keep the price high, the more market 6 ppp oem have a high degree of market power. power each firm will have ‘ Problems and Applications 1. Arce farmer named Juan experiences a rise in his costs of production. Someone com- ‘ments, "Higher costs for Juan today mean higher rice prices forthe consumer at some time in the future” Do you agree with this comment? Explain your answer. 2. Amajor producer of beer—such as San Miguel Beer Corporation—experiences a rise in its costs of production. Someone comments Higher costs for San Miguel today mean higher beer prices for the consumer at some time in the future” Do you agree with this comment? Explain your answer. 3. "Several supermarkets typically serve a densely populated area; therefore, @ supermarket that faces competition from many other supermarkets cannot have market power” Evalu- ate this statement. 4, Grocery stores that are open 24 hours a day normally charge higher prices than supermar- kets. Why? Use the concept of pric elasticity of demand in your answer. 5. Wholesale and retail price of mass-market" jeans is much lower than the wholesale and re- tall price of jeans witha designer label. Why? Use the concept of price elasticity of demand inyour answer. 6, Do fastfood restaurants atthe local mall charge the same price for an order of fied chick- en? fnot, explain the differences in the prices they charge. 7. Suppose the dentists in your town charge the same price fora certain type of dental ser- vice. I this because they are colluding—that i, the dentists come together, pick a price, and stick to it? Explain your answer, 8. The owner of the only movie theater in town learned that people watching movies before 5 pm. are much more price-sensitive than people watching movies after 5 pam. The costs of showing a movie are exactly the same before 5 pim. and after 5 pm. Give the owner some specific advice on how to maximize his profit.