UNIT 7 – THE FIRM AND ITS CUSTOMERS:

7.1: BREAKFAST CEREAL: CHOOSING A PRICE:

How would you choose price for a product? You need to consider demand curve, as your decision will affect your
profits, and consider costs. Suppose unit cost was $2. To maximise profit, you would produce how much you expect
to sell.

Cost = unit cost x quantity

Total revenue = price x quantity
Profit= total revenue – total costs

Isoprofit curves can be drawn.

To achieve a high profit, you want price and

quantity to be as high as possible, but this is
constrained by demand curve.

- Horizontal line shows where profit is zero

- Profit would be maximised at E, you
reach highest possible isoprofit curve
while remaining in the feasible set, where
demand is tangent to the isoprofit curve.
- The isoprofit curve is your indifference
curve, and its slope at any point
represents the trade-off you are willing to
make between P and Q—your MRS. You
would be willing to substitute a high price
for a lower quantity if you obtained the
same profit.
- The slope of the demand curve is the
trade-off you are constrained to make—
your MRT, or the rate at which the
demand curve allows you to ‘transform’ quantity into price. You cannot raise the price without lowering the quantity,
because fewer consumers will buy a more expensive product.

 When quantity is low, profit is low

 Increase in quantity cause profit to rise
until maximum point E
 Profit falls to zero where price equals unit
cost
7.2: ECONOMIES OF SCALE AND THE COST ADVANTAGES OF LARGE-SCALE PRODUCTION:

A reason why large firm are more profitable is because it produces output at lower cost per unit. This may be due to
two reasons:
 Technological advantages: Large-scale production often uses fewer inputs per unit of output.
 Cost advantages: In larger firms, fixed costs such as advertising have a smaller effect on the cost per unit. And
they may be able to purchase their inputs at a lower cost because they have more bargaining power.

Economics of scale or increasing returns describe technological advantages of large-scale production.

If we increase all inputs by a given proportion, and it:

 increases output more than proportionally, then the technology is said to exhibit increasing returns to scale
in production or economies of scale
 increases output less than proportionally, then the technology exhibits decreasing returns to scale in
production or diseconomies of scale
 increases output proportionally, then the technology exhibits constant returns to scale

Economies of scale may be due to specialisation within the firm, or due to engineering reasons. There are also built
in diseconomies of scale.
Cost advantages:

Cost per unit may fall as firm produces more output. This happens if there is a fixed cost that doesn’t depend on
output. For example, cost of research and development, obtaining a patent and product design.

Moreover, large firms are able to purchase their inputs on more favourable terms, because they have more
bargaining power.

Demand advantages:

People may be more likely to buy if a firm already has lots of users. These demand side benefits are called network
economies of scale.

7.3: PRODUCTION: THE COST FUNCTION FOR BEAUTIFUL CARS:

To decide a price manager must know the demand and

production costs.

For producing and selling cars firm needs premises and

equipment etc. The firm’s owners (shareholders) won’t invest
in the firm if they could make better use of money by investing
elsewhere, what they can earn elsewhere is an opportunity
cost.
 Top panel shows cost at different levels of output
 Some costs do not vary these care fixed costs, the only
fixed costs are F, where Q equals 0.
 As quantity increases, total cost rises. And firm
employs more workers
 Lower panel shows average cost.
 Average cost is lowest at B

At each point on the cost function, the marginal cost (MC) is

the additional cost of producing one more unit of
output, which corresponds to the slope of the cost
function. If cost increases by ∆C when quantity is
increased by ∆Q, the marginal cost can be estimated by:
  Top panel shows cost function
 Lower panel shows average cost curve and marginal cost
curve
 Increasing marginal cost leads to average cost to rise

 At Q(0) MC < AC.

 AC curve slopes downwards because as
more is produced it decreases
 At D AC rise, when AC < MC, AC curve slopes
upwards
 When AC = MC AC is at its lowest point. At
this point AC is flat

7.4: DEMAND AND ISOPROFIT CURVES: BEAUTIFUL CARS:

Cars are differentiated products. We expect a firm selling differentiated products to face a downward sloping demand
curve.
Demand curve:

Each consumer has a willingness to pay (WTP) for a car, which depends on how much the customer values it. The
consumer will buy a car if price is less than or equal to WTP.

The isoprofit curves:

Firms profit is the different between its revenue and total costs C(Q).

Profit = PQ -C(Q)
This gives us the economic profit. Economics profit is
the additional profit above the minimum return
required by shareholders.

 If P = AC firms’ economic profit is zero.

 Average cost is decreasing when Q is less than
40, and increasing otherwise.
 It has increasing marginal costs, as it is
upward sloping line. Curves cross at B. The
higher isoprofit curves show higher profits.
  Profit is higher on the curves closer to the top right corner.

Isoprofit curves slope downwards where P>MC, and upwards where P<MC. The difference between the price and
marginal cost is profit margin.

Slope of isoprofit curve = -profit margin/ quantity

7.5: SETTING PRICE AND QUANTITY TO MAXIMISE PROFIT:

 to maximise profit firm should choose point E,

which is on highest isoprofit curve.
 This is where the slope of demand curve equals
slope of isoprofit curve.
 The demand curve is the feasible frontier, and
its slope is the marginal rate of transformation
(MRT)of lower prices into greater quantity sold.
 The isoprofit curve is the indifference curve,
and its slope is the marginal rate of substitution
(MRS)in profit creation, between selling more
and charging more.
At E MRT=MRS

Constrained optimization:

Profit maximisation problem is another constrained choice problem.

7.6: LOOKING AT PROFIT MAXIMISATION AS MARGINAL REVENUE AND MARGINAL COST:

Instead of using isoprofit curves we use marginal revenue to find profit max.

 As we move down the demand curve, price and MR falls by

more.
 At D the gain on additional cars is outweighed by loss, so MR is
negative
 MR and MC cross at E
 Where MR > MC it would be better to increase production as
selling more gives more revenue than cost
 Profit is maximised where MR = MC

7.7: GAINS FROM TRADE:

People volunteer in economic interactions for economic rent. The total surplus for parties is a measure of the gains
from exchange.
We have assumed:

 Firms decide how many items to produce and sets a price

 Consumers decide whether to buy
 To find the total surplus by consumers you add the surplus of each buyer. This is shown by shaded orange
triangle between demand curve and line where
price is P*.
 Producer surplus is purple shaded area between
vertical line and marginal cost curve.

Pareto efficiency:

The allocation of cars in this market is not pareto

efficient. As there are some consumers who do not
purchase at firms chosen price, but would be willing to pay more than the cost to the firm.
 Firms profit maximising price is at E, but there are
unexploited gains from trade
 Suppose firm chooses F instead. This allocation is
pareto efficient.
 Consumer surplus increases
 Producer surplus decreases, but total surplus has
increased
 At E there was a deadweight loss

7.8: THE ELASTICITY OF

DEMAND:
The price elasticity of demand is a measure of responsiveness of consumers to a price
change.

Elasticity is related to the slope of the demand curve. If curve is quite flat, elasticity is high. A steeper demand curve
corresponds to a lower elasticity.
  If demand is inelastic, firm cannot increase Q without a large drop in P so MR < 0.
 Profit margin is affected by elasticity.
7.9: USING DEMAND ELASTICITIES IN GOVERNMENT POLICY:

If government puts a tax on a good, the tax will raise the price paid, so effects of tax depend on elasticity of demand:

 If demand is highly elastic: A tax will cause a large reduction in sales. That may be intentional, as when
governments tax tobacco to discourage smoking because it is harmful to health.
 If a tax causes a large fall in sales: It also reduces potential tax revenue.

So, if government wishes to raise tax revenue, they should choose tax products with inelastic demand.
7.10: PRICE-SETTING, COMPETITION, AND MARKET POWER:

Our analysis of firms pricing decision applies to any firm producing differentiated products. Monopolies are firms
selling differentiated goods where they have a lot of power. Firms set prices way above marginal cost. This is not
pareto efficient and is a case of market failure. It creates a deadweight loss.
The manufacturers of specialised cars, face little competition so have less elastic demand. It can set high prices and
so earns monopoly rents. A firm will be in a strong position if it has few close substitutes, we say a firm like this has
market power.

Competition policy: Potential consumer surplus is lost because prices are raised and fewer consumers buy, so there
is a deadweight loss.

A particular concern is when there are a few firms that may form a cartel (group that collude to keep prices high).
Competition policy is used to prevent this.

7.11: PRODUCT SELECTION, INNOVATION, AND ADVERTISING:

Firm may be able to increase demand through advertising and marketing. Ideally goods chosen to be produced would
be with high demand and low elasticity. Elasticity can be kept low through having copyright and patent laws.
Advertising is used to inform consumers of products and its USP.

7.12: PRICES, COSTS, AND MARKET FAILURE:

Market failure occurs when market allocation of a good is pareto inefficient.

Product differentiation is not the only reason for the ability for a price to be made above marginal cost. A second
reason is decreasing average costs, perhaps due to economies of scale, or input prices declines as firm purchases
larger quantities. In such cases, average cost of production is greater than marginal cost, and average cost slopes
downwards. Price must equal at least average cost to not make a loss, so it is above marginal cost.

Utilities typically have increasing returns to scale. If a single firm can supply whole market at lower average cost than
two firms, the industry is said to be a natural monopoly. Policymakers may not be able to induce firms to lower their
prices by promoting competition, since average costs would rise with more firms in the market.

A price above marginal cost whatever the reason results in market failure. Too little is purchased, so there is a
deadweight loss.