Unit 7
THE FIRM AND ITS CUSTOMERS
OUTLINE
A. Introduction
B. Production: Key concepts
C. Pricing and Production Decisions: Profit
maximization
D. Gains from Trade
E. Price Elasticity of Demand
A. Introduction
In all developed countries, most people work for large firms.
A firm’s success and ability to grow partly depends on its
pricing and production decisions.
The Context for This Unit
Interactions between firms and workers determine wages,
(Unit 6)
which are part of a firm’s production costs.
Other key decisions for firms include choosing product prices
and quantities to produce.
• How do these decisions depend on demand and
production costs?
• How can policies affect the division of surplus between
firms and customers?
This Unit
• Model of interactions between customers and profitmaximising firms producing differentiated products
• Factors that affect the firm’s choice of price and quantities
produced (costs, price elasticity, market power)
• Surplus: measuring the gains from trade
B. Production: Key concepts
Firms are profit maximizers
• In order to maximize profits, firms can either increase revenue or
reduce costs.
• To increase revenue they can charger a higher price but as we have
seen that can only be to a certain point OR they can sell more units
• The other way would be to reduce costs.
How does a firm reduce costs?
1. Technological advantages: using fewer inputs or using large-scale
production which creates economies of scale
2. Cost advantages: some costs might be fixed across multiple
products such as transport and marketing costs or the firm can
purchase inputs at a lower cost because they have greater
bargaining power or the firm uses R&D to find cost-effective ways
to produce the good
Cost Function
What are the costs we are dealing with?
• Total Cost
• Fixed Cost
• Variable Cost
• Average Total Cost
• Average Fixed Cost
• Average Variable Cost
Short Run Cost Function
Cost functions
To make pricing and production decisions, managers need to know
the costs of production.
Cost functions show how total production costs vary with quantity
produced.
Average cost
Average cost (AC): Average cost
per unit produced.
• Calculated as the slope of the
ray from the origin to a given
point on the cost function.
In this example, average costs
decrease at first (economies of
scale) but then increase (e.g.
overtime, machine breakdown).
Marginal cost
Marginal cost (MC): the effect on total cost of producing one
additional unit of output.
• Calculated as the slope of the cost function at a given point.
In this example, marginal costs increase with production.
Calculating Marginal Cost
• Total cost of producing 20 cars is 80,000
• Total cost of producing 21 cars is 84,000
• What is the MC of producing the 21st car?
Calculating Marginal Cost
• Total cost of producing 20 cars is 80,000
• Total cost of producing 21 cars is 84,000
• What is the MC of producing the 21st car?
MC = Total cost/change in units = 84,000 – 80,000/21-20= 4,000/1 =
4,000
Cost of Production Example
Relationship between MC and AC
Cost Output Function in the Long Run
Long Run Total Average Cost
Long Run Marginal Cost
Why is SRAC U shaped?
Why is LRAC U shaped?
• In the long run there is no fixed factor of production and hence there is no fixed cost.
All costs are variable.
• Hypothetically in the long run a firm can change the plant size but this is a significant
investment which the firm may not always have the finances for so there may be a
time lag in which diseconomies of scale set in.
• Even in larger scale setups, a firm may face both economies of scale (which reduces
average cost per unit) an diseconomies of scale (inefficiencies, communication and
cooordination problems).
If inputs increase by a given proportion,
and production…
Then the technology exhibits…
Increases more than proportionally
Increasing returns to scale in production
Economies of scale
Increases proportionally
Constant returns to scale in production
Increases less than proportionally
Decreasing returns to scale in production
Diseconomies of scale
Types of Economies of Scale
• Bulk buying
• Technological economies
• Marketing advantages
• Managerial
• Financial
Types of Diseconomies
• Managerial problems
• Coordination problems
• Problems with suppliers (inputs) or markets (outputs)
• Market congestion
Question 1:
Answer 1:
Question 2:
Answer 2:
Question 3:
Answer 3:
Working:
New AC = ((25x2)+15)/3 = 21.25 which is lower than 25
C. Pricing and Production Decisions:
Profit maximization
Demand curve
To make pricing and production decisions, managers also need
to know the demand for the firm’s product.
Demand curve = quantity that
consumers will buy at each price.
In theory, firms can estimate the
demand curve for their product
by surveying a large number of
consumers.
Isoprofit curve
(Economic) Profit = Total revenue – Total costs
(Costs include the opportunity cost of capital)
Isoprofit curves show pricequantity combinations that give
the same profit.
The shape of a firm’s cost
function affects the shape of
their isoprofit curves.
Profit maximisation
The firm’s constrained optimization problem is analogous to
the consumer’s from Unit 3.
• Demand curve = Firm’s feasible
frontier (slope = MRT)
• Isoprofit curves = Firm’s
indifference curves (slope = MRS)
Firm maximizes profits by choosing
point where MRS = MRT
Profit Maximization
Profit-maximization can also be
described in terms of revenue and costs.
Marginal revenue (MR) = change in
revenue from selling an additional unit
(net effect of decreasing price and
increasing quantity sold)
Firm maximizes profits by choosing
point where MR = MC
D. Gains from Trade
Measuring Surplus
Consumer surplus (CS) = the total
difference between willingness-topay and purchase price
Producer surplus (PS) = the total
difference between revenue and
marginal cost
(Profit = PS – fixed costs)
Total surplus = Consumer surplus + Producer surplus
= Total gains from trade (shaded area)
Deadweight Loss
Deadweight loss = a loss of total
surplus relative to a Pareto
efficient allocation (unexploited
gains from trade)
Total surplus is highest when
Demand = Marginal Cost
(Pareto efficient allocation)
E. Price Elasticity of Demand
Price Elasticity of Demand
A firm’s pricing decision depends
on the slope of the demand curve.
Price elasticity of demand =
degree of responsiveness (of
consumers) to a price change.
Example
Answer
PED = - (change in qty demanded/ change in price) x (original p/original
q)
Change in qty demanded = 120-100 = 20
Change in price = 10-9 =1
PED =- (20/1) x (10/100) =- 200/100 = - 2 %
Is this demand elastic or inelastic?
Always look at absolute value to determine
this
• Elastic demand > 1
• Inelastic demand is between 0 and 1
Perfectly Elastic Demand
Perfectly Inelastic Demand
Relatively Elastic Demand
Relatively Inelastic Demand
Factors that affect Price Elasticity
• Number of substitutes
• Type of good
• Brand loyalty
Price Elasticity and Profits
A firm’s markup (profit margin as a proportion of the price)
is inversely proportional to price elasticity of demand.
Elastic demand
Inelastic demand
Price Elasticity and Policy
• The effect of good-specific taxes
depends on the elasticity of
demand for those goods.
• Governments raise more tax
revenue by levying taxes on priceinelastic goods.
• Several countries e.g. Denmark
and France have introduced taxes
on unhealthy foods – to reduce
consumption not to raise revenue.
Price Elasticity and Market Power
A firm’s profit margin depends on the elasticity of demand, which
is determined by competition:
• Demand is relatively inelastic if there are few close substitutes
• Firms with market power have enough bargaining power to
set prices without losing customers to competitors
Competition policy (limits on market power) can be beneficial to
consumers when firms collude to keep prices high.
Market Power: Monopolies
Example of market power: A firm selling specialized products.
• They face little competition and hence have inelastic demand.
• They can set price above marginal cost without losing customers,
thus earning monopoly rents.
• This is a form of market failure because there is deadweight loss.
A natural monopoly arises when one firm can produce at lower
average costs than two or more firms e.g. utilities.
Instead of encouraging competition, policymakers may put price
controls or make these firms publicly owned.
Gaining market power
Firms can increase their market power by:
• Innovating – Technological innovation can allow firms to
differentiate their products from competitors’ e.g. hybrid cars.
Firms that invent a completely new product may prevent
competition altogether through patents or copyright laws.
• Advertising – Firms can attract consumers away from competing
products and create brand loyalty. Advertising can be more
effective than discounts in increasing demand for a brand.
Both of these tactics can shift the firm’s demand curve.
Summary
1. Model of a firm with market power (price-setter)
• Price and production decisions depend on a firm’s
demand curve and cost function.
• Profit-maximising choice where MRS = MRT
• Or, in terms of revenue and costs, where MR = MC
2. Surplus measures the gains from trade
• Total surplus = Producer surplus + Consumer surplus
• Deadweight loss when allocation not Pareto efficient
• Price elasticity of demand affects surplus and profits
In the next unit
• Model of supply and demand interactions under
perfect competition (no market power)
• Determinants of competitive equilibrium
• Similarities and differences between price-taking
and price-setting firms
Question 1
Let the cost of one box of cereal be $2. Write the formulas for revenue,
cost and profit.
Answer 1
Profit = Revenue – costs
Revenue = price x quantity = pQ
Cost = cost x quantity = 2Q
Profit = pQ – 2Q = (p-2) Q
Question 2
• If the price of both organic eggs and non-organic eggs
increases, which one would have the highest responsiveness of
quantity demanded to this change in price?
Answer 2
Organic eggs because they would be considered a luxury good.
Question 3: Calculate CS and PS in the following diagram.
Answer 3
Consumer surplus = 0.5 x h x b = 0.5 x (4.25-2) x 5000 = 5625
Producer surplus = 0.5 x h x b = 0.5 x 1 x 5000 = 2500
Question 4: Calculate DWL and gains from trade.
Answer 4
DWL = 0.5 x 1000 x 1 = 500
Total surplus (entire triangle) = 0.5 x 5000 x 3.25 = 8125
Gains from trade (green area) = Total surplus – DWL
= 8125 – 500 = 7625