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Funded by the Institute for New Economic Thinking with
additional funding from Azim Premji University and Sciences Po
7THE FIRM AND ITS CUSTOMERS
HOW A PROFIT-MAXIMISING FIRM PRODUCING A DIFFERENTIATED PRODUCT
INTERACTS WITH ITS CUSTOMERS.You will learn:
What the product demand curve is.
What the firms marginal cost is.
What a differentiated product is.
How a firm without close competitors chooses the price and
quantity that maximises its profits, and can increase its profits
through product selection and advertising.
What the gains from trade are and how they are distributed
between consumers and the firm.
What the elasticity of demand is, how it affects the firms price
and profit margin, and how an economic policy maker could use this
information in the design of tax and competition policy.
February 2015 beta
See www.core-econ.org for the full interactive version of The
Economy by The CORE Project. Guide yourself through key concepts
with clickable figures, test your understanding with multiple
choice
questions, look up key terms in the glossary, read full
mathematical derivations in the Leibniz supplements, watch
economists explain their work in Economists in Action and much
more.
Courtesy of Federal Archives, Germany, Photo: Erich Krueger
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coreecon | Curriculum Open-access Resources in Economics 2
pile it high and sell it cheap was the motto of Jack Cohen, who
founded Tesco in 1919. Tesco is now the market leader in the UK
grocery market, with higher profits than any other retailer in the
world except Walmart. Keeping the price low as Cohen recommended is
one possible strategy for a firm seeking to maximise its profits:
the profit on each item is small, but the low price may attract so
many customers that total profit is high. Other firms may adopt
quite different strategies; Apple sets high prices for iPhones and
iPads, increasing its profits by charging a price premium, rather
than lowering prices to reach more customers. For example, between
April 2010 and March 2012, profit per unit on Apple iPhones was
between 49% and 58% of the price. During the same period, Tescos
operating profit per unit was between 6.0% and 6.5%.
A firm needs information about demand to decide what price to
charge: how much potential consumers are willing to pay for its
product. Figure 1 shows the demand curve for Apple-Cinnamon
Cheerios, a ready-to-eat breakfast cereal introduced by the company
General Mills in 1989. In 1996, the economist Jerry Hausman used
data on weekly sales of family breakfast cereals in US cities to
estimate how the quantity of cereal customers would wish to buy,
per week in a typical city, would vary with the price per pound.
You can see from Figure 1 that if the price were $3, for example,
customers would demand 24,000 pounds of Apple-Cinnamon Cheerios.
The lower the price, the more customers wish to buy.
8
7
6
5
4
3
2
1
0
0
8,00
0
16,000
24,000
32,000
40,000
48,000
56,000
64,000
72,000
80,000
Pric
e P:
dol
lars
per
pou
nd
Quantity Q: pounds of Cheerios
Demand curve
Figure 1. Estimated demand for Apple-Cinnamon Cheerios.
Source: Adapted from Figure 5.2 of Hausman, J. 1996. Valuation
of New Goods under Perfect and Imperfect Competition. In: Timothy
F. Bresnahan and Robert J. Gordon, 1996. The Economics of New
Goods. Chicago: University of Chicago Press, pp. 207-248.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 3
INTERACT
Follow figures click-by-click in the full interactive version at
www.core-econ.org.
If you were the manager at General Mills, how would you choose
the price for Apple-Cinnamon Cheerios in this city, and how many
pounds of cereal would you produce? Suppose that the unit costthe
cost of producing each poundof Apple-Cinnamon Cheerios is $2. Then
the calculation you need is:
Profit = (price unit cost) quantity = (P 2) Q
Figure 2 shows the isoprofit curves for different choices of
price and quantity. Just as indifference curves join points in a
diagram giving the same level of utility, isoprofit curves join
points that give the same level of profit. You could make $60,000
profit by selling 60,000 pounds at a price of $3, or 20,000 pounds
at $5, or 10,000 pounds at $8, or in many other ways. The darkest
blue curve shows all the possible ways of making $60,000 profit.
The lightest blue line shows the choices of price and quantity
where profit is zero: if you set a price of $2, you would be
selling each pound of cereal for exactly what it cost you to
produce, making no profit whatever the amount you sold. So the
zero-profit line is horizontal, joining all the points where P =
2.
Quantity Q: pounds of Cheerios
Pric
e P:
dol
lars
per
pou
nd
10
9
8
7
6
5
4
3
2
1
0
0
8,00
0
16,000
24,000
32,000
40,000
48,000
56,000
64,000
72,000
80,000
Isoprofit curve: $60,000Isoprofit curve: $34,000Isoprofit curve:
$10,000Isoprofit curve: $0
Figure 2. Isoprofit curves for the production of Apple-Cinnamon
Cheerios.
Source: Isoprofit data is illustrative only, and does not
reflect the real-world profitability of the product.
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coreecon | Curriculum Open-access Resources in Economics 4
Of course you would like both price and quantity to be as high
as possible, to maximise your profit. But you know from the demand
curve that if you choose a high price you will only be able to sell
a small quantity; and if you want to sell a large quantity, you
must choose a low price. The only feasible choices are the points
in the diagram on or below the demand curve in Figure 3: we call
these points the feasible set. Figure 3 shows you how to find the
profit-maximising choice of price and quantity: the highest
isoprofit curve you can reach while remaining in the feasible set
is the middle one, which is tangent to the demand curve. Your best
strategy is to choose point E: you should produce 14,000 pounds of
cereal, and sell it at a price of $4.40 per pound.
Pric
e P:
dol
lars
per
pou
nd
10
9
8
7
6
5
4
3
2
1
0 0
8,00
0
16,000
24,000
32,000
40,000
48,000
56,000
64,000
72,000
80,000
Isoprofit curve: $60,000Isoprofit curve: $34,000Isoprofit curve:
$10,000Isoprofit curve: $0
Demand curve
E
Quantity Q: pounds of Cheerios
Figure 3. The profit-maximising choice of price and quantity for
Apple-Cinnamon Cheerios.
Source: Isoprofit data is illustrative only, and does not
reflect the real-world profitability of the product. Demand curve
data from Hausman, as above.
7.1 THE PRODUCT DEMAND CURVE
for any product that consumers might wish to buy, the product
demand curve is a relationship that tells you the number of items
(the quantity) they will buy at each possible price. Lets think
about a market for a particular model of car. To keep things
simple, imagine that there are 100 potential consumers who would
each buy one car of this type, today, if the price were low
enough.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 5
Each consumer has their own willingness to pay (WTP) for a car,
which depends on how much they personally value it (given that they
have the resources to buy it). A consumer will buy a car if the
price is less than, or equal to, that persons WTP. Suppose we line
up the consumers in order of WTP, highest first, and plot a graph
to show how the WTP varies along the line (Figure 4). Then if we
choose any price, say P = $3,200, the graph shows the number of
consumers whose WTP is greater than or equal to P. In this case, 60
consumers are willing to pay $3,200 or more, so the demand for cars
at a price of $3,200 is 60.
Pric
e P:
WTP
($)
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
A
Quantity Q: number of consumers
0 10 20 30 40 50 60 70 80 90 100 110 120
Figure 4. The demand for cars (per day).
If P is lower, there is a larger number of consumers willing to
buyso the demand is higher. Demand curves are often drawn as
straight lines, as in this example, although there is no reason to
expect them to be straight in reality: we saw that the demand curve
for Apple-Cinnamon Cheerios was not straight. But we do expect
demand curves to slope downward: as price rises, the quantity
demanded by consumers falls. Conversely, when the available
quantity is low, it can be sold at a high price. This relationship
between price and quantity is sometimes known as The Law of
Demand.
TEST YOUR UNDERSTANDING
Test yourself using multiple choice questions in the full
interactive version at www.core-econ.org.
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coreecon | Curriculum Open-access Resources in Economics 6
7.2 PRODUCTION: THE FIRMS COST FUNCTION
a car manufacturer deciding how many cars to produce, and what
price to set, must take into account the costs of production.
There are many costs of producing and selling cars. The firm
needs premisesa factoryequipped with machines for casting, forging,
assembling and welding car bodies. It may rent them, from another
firm perhaps, or raise financial capital in order to invest in
premises and equipment for itself. Then it must purchase the raw
materials and components, and pay production workers to operate the
equipment. Other workers will be needed to manage the production
process and market and sell the finished cars.
The firms ownersthe shareholderswould not be willing to invest
in the firm if they could make better use of their money by
investing and earning profits elsewhere. What they could receive if
they invested elsewhere, per dollar of their investment, is termed
the opportunity cost of capital. One component of the cost of
producing cars is the amount that has to be paid out to
shareholders to cover the opportunity cost of capitalthat is, to
induce them to continue to invest in the assets the firm needs to
produce cars.
The more cars the firm produces, the higher its total costs will
be. The upper panel of Figure 5 shows how total costs might depend
on the quantity of cars, Q, produced. This is the firms cost
function, C(Q).
Tota
l cos
t of p
rodu
ctio
n,
C(Q
)Av
erag
e co
st o
f pr
oduc
tion
350,000
0
6,000
0
Quantity of cars, Q
C0=A
A
F
B
B
D
D
88,000
4,4003,9603,600
20 40 640
Average cost (AC) of production at A= slope of line OA= C0 / Q0=
4,400
AC at B= slope of line OB= 3,600
AC at D= slope of line OD = 3,960
O 644020
Q2Q1Q0
Figure 5. The firms cost function and average costs.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 7
Some costs may not vary with the number of cars: for example,
once it has decided on the size of factory and invested in
equipment, the premises and equipment costs will be the same
irrespective of output. These are called fixed costs. So when Q =
0, the only costs are the fixed costs, F. As Q increases, costs
rise: the firm needs to employ more production workers. At point A,
20 cars are produced (we call this Q0) costing $88,000 (we call
this C0). When the firm operates at this scale, the average cost of
producing a car is C0 divided by Q0, which is shown by the slope of
the line from the origin to A: average cost is $88,000/20 = $4,400.
We have also plotted the average cost at point A on the lower
panel.
As output rises above A total costs rise, but the average
costthe cost per car produced falls: the fixed costs are shared
between more cars. When average costs fall as output increases, we
say that the firm has increasing returns to scale or economies of
scale. At point B, with output of 40 cars, the total cost is
$144,000 so the average cost has fallen to $3,600.
Point B is where the average cost is lowest. When production
increases further, beyond point B, the line showing the average
cost gets steeper again. The average cost rises; at these higher
levels of production the firm has decreasing returns to scale
(sometimes called diseconomies of scale). At point D, 64 cars are
produced and the average cost has risen to $3,960. For example,
this might happen if the firm has to increase the number of shifts
per day on the assembly line to raise output. Average costs might
increase if it has to pay overtime rates, and equipment breaks down
more frequently.
If we calculate the average cost at every value of Q, we can
draw the average cost (AC) curve in the lower panel of Figure 5. At
low levels of production the average cost is decreasing (the firm
has increasing returns to scale)so the AC curve slopes downward.
The average cost is lowest at point B. After that the AC curve
slopes upward, corresponding to decreasing returns to scale.
Figure 6 shows how to find the marginal cost of a car: that is,
the cost of producing one more car. Suppose the firm is producing
20 cars at point A. The total cost is $88,000. The marginal cost is
the cost of increasing output from 20 to 21. This would increase
total costs by an amount which we call C (delta C), equal to
$2,000. You can see from the triangle drawn at A that the marginal
cost is equal to the slope of the cost function at that point. We
have plotted the marginal cost at point A on the lower panel of
Figure 6.
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coreecon | Curriculum Open-access Resources in Economics 8
Mar
gina
l cos
t of p
rodu
ctio
n
0
6,000
0
A
B
D
Quantity of cars, Q
Tota
l cos
t of p
rodu
ctio
n, C(Q
) ($)
350,000
0
A
F
D
C1
AD C
1
MC
AC
5,520
3,600
2,000
Q0 Q1 Q2
C0= 88,000
C= 2,000
C= 3,600
C= 5,520
6440200
644020
Figure 6. The marginal cost of a car.
Now look at point D, where Q = 64. The cost function is much
steeper there. The marginal cost of producing an extra car is
higher at point D, at which C = $5,520. At point B, the curve is
steeper than at A, but flatter than at D: the marginal cost is
$3,600. If you look at the shape of the whole cost function you can
see that when Q = 0 it is quite flat, so the marginal cost is low.
As the quantity of output increases, the cost function gets
steeper, and the marginal cost gradually rises.
By calculating the marginal cost at every value of Q, we can
fill in the whole of the marginal cost curve in the lower panel of
Figure 6. Remember that for each value of Q, the marginal cost is
the cost of increasing output from Q to Q+1, which corresponds to
the slope of the cost function. As Q increases the slope of the
cost function rises steadily, so the graph of marginal cost is an
upward-sloping line. LEIBNIZ 11 defines mathematically the concepts
of average and marginal cost.
LEIBNIZ
For mathematical derivations of key concepts, download the
Leibniz boxes from www.core-econ.org.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 9
Now look at the shapes of the AC and MC curves. You can see that
at values of Q where the AC is greater than the MC, the AC curve is
downward-sloping, and it is upward sloping where AC is less than
MC. This is not just a coincidence: it happens whatever the shape
of the total cost function. If the marginal costthe cost of
producing one more caris less than the average cost, then producing
one more car will lower the average cost of producing cars. And if
the marginal cost is greater than the average cost, producing one
more car will raise the average cost.
This means the two curves cross at a point where the AC is flat
(the slope is zero). At point B, where the average cost is lowest,
the average and marginal costs are equal.
DISCUSS 1: THE COST FUNCTION FOR APPLE-CINNAMON CHEERIOS
Of course, the cost function in Figure 5 is not the only
possible shape for a cost function. For Apple-Cinnamon Cheerios, we
assumed the cost of producing every pound of cereal was equal to
$2, irrespective of the quantity produced, corresponding to
constant returns to scale. Try drawing the cost function for this
case. You should find that it is a straight line through the
origin. What do the marginal and average costs functions look
like??
The economists Rajindar and Manjulika Koshal studied the cost
functions of public universities in the US. They estimated the
marginal and average costs of educating graduate and undergraduate
students in 171 public universities in the academic year 1990-1,
and found increasing returns to scale. They also found that the
universities benefitted from economics of scope: that is, there
were cost savings from producing several productsgraduate
education, undergraduate education, and researchtogether.
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coreecon | Curriculum Open-access Resources in Economics 10
DISCUSS 2: COST FUNCTIONS FOR UNIVERSITY EDUCATION
Below you can see the average and marginal costs per student for
the year 1990-1 that Koshal and Koshal calculated from their
research.
STUDENTS MC ($) AC ($) TOTAL COST ($)
Undergraduates
2,750 7,259 7,659 21,062,2505,500 6,548 7,348 40,414,0008,250
5,838 7,038
11,000 5,125 6,727 73,997,00013,750 4,417 6,417 88,233,75016,500
3,706 6,106 100,749,000
STUDENTS MC ($) AC ($) TOTAL COST ($)
Graduates
550 6,541 12,140 6,677,0001,100 6,821 9,454 10,399,4001,650
7,102 8,6722,200 7,383 8,365 18,403,0002,750 7,664 8,249
22,648,7503,300 7,945 8,228 27,152,400
1. Explain how you can tell from the data that returns to scale
are increasing for both graduates and undergraduates.
2. Using the data for average costs, find the missing figures in
the total cost columns.3. Plot the marginal and average cost curves
for undergraduate education on
a graph with costs on the vertical axis, and the number of
students on the horizontal axis. On a separate diagram plot the
equivalent graphs for graduates.
4. What are the shapes of the total cost functions for
undergraduates and graduates? You could sketch them using what you
know about MC and AC; alternatively you could plot them more
accurately using the numbers in the Total Cost columns. (Hint: they
are not straight lines.)
5. What are the main differences between the universities cost
structures for undergraduates and graduates? Can you think of any
explanations for the shapes of the graphs you have drawn?
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 11
7.3 SETTING THE PRICE
not all cars are the same. Cars are differentiated products.
Each make and model is produced by just one firm, and has some
unique characteristics of design and performance that differentiate
it from the cars made by other firms.
Like the producer of Apple-Cinnamon Cheerios, the car
manufacturer chooses the price, P, and the quantity of cars to
produce, Q, taking into account its production costs, and what it
knows about demand for its own particular type of car. The firms
profit is the difference between its revenue (the price multiplied
by quantity sold) and its total costs, C(Q):
Profit = price quantity total costs = PQ C(Q)
Equivalently, it is the number of units of output multiplied by
the profit per unit, which is the difference between the price and
the average cost:
Profit = Q(P C(Q)/Q)
This calculation gives us what is known as the economic profit.
Remember that the cost function includes the opportunity cost of
capitalthe payments that must be made to the owners to induce them
to hold shares, which are referred to as normal profits. Economic
profit is the additional profit above the minimum return required
by shareholders.
Figure 7 shows the isoprofit curves for the car manufacturer
whose cost function is shown in Figure 6. The curves look similar
to those for Cheerios in Figure 2, but there are some differences
because the car manufacturers cost function has a different shape.
The lightest blue curve shows the zero-economic-profit curve: the
combinations of price and quantity for which economic profit is
equal to zerobecause the price is just equal to the average cost at
each quantity.
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coreecon | Curriculum Open-access Resources in Economics 12
Pric
e, M
argi
nal c
ost (
$)10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Quantity of cars, Q
0 10 20 30 40 50 60 70 80 90 100 110 120
G
H
B
Isoprofit curve: $160,000
Marginal cost
Isoprofit curve: $56,000Zero-economic-profit curve (AC
curve)
Figure 7. Isoprofit curves for the car manufacturer.
Since the price is equal to the average cost at every point on
the zero-economic-profit curve, it is identical to the average cost
curve that we drew in Figure 6. Remember that the slope of the
average cost curve depends on the difference between average and
marginal cost. The marginal cost curve is the upward-sloping line
in Figure 7. When the quantity is low, average cost is high so the
price must be high just for the firm to break even. Then as we saw
before, the average cost falls as quantity increases until we reach
point B, and rises again where the marginal cost is greater than
the average cost. So the zero-economic-profit curve slopes downward
initially, and then upward when quantity is high.
The darker blue curves show higher levels of profit: in each
case profit is the same at every point on the curve; and profit is
higher on the curves further from the origin. At point G, for
example, where the firm makes 28 cars, the price is $9,520 but the
average cost is $3,806. The firm would be making a profit of $5,714
on each car, and its total profit would be $160,000. As quantity
increases the shape of the isoprofit curve follows the shape of the
average cost curve, but they gradually get closer to each
other.
DISCUSS 3: LOOKING AT ISOPROFIT CURVES
Why do the higher isoprofit curves get closer to the average
cost curve as quantity increases?
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 13
We already know that at point B, where average cost is lowest,
MC is equal to AC. So on the zero-economic-profit curve, the price
is lowest at the point where it is equal to marginal cost. You can
see in Figure 7 that each of the isoprofit curves has the same
property: they slope down when the price is greater than the
marginal cost, and up when the price is less than the marginal
cost. And the lowest price on each isoprofit curve is equal to the
marginal cost at that point.
The explanation for this property of isoprofit curves is similar
to the one for the AC curve. At point G,the price is much higher
than the marginal cost, so if you made one more car, and sold it at
this price, your profit would rise . For profit to stay constant,
the price would have to be lower: hence the curve slopes down. At
point H, however, the price is lower than the marginal cost so if
you made one more car you would need to raise the price to keep
profit constant. In EINSTEIN 1 we work out a formula for the slope
of an isoprofit curve, which shows that it depends on the
difference between the price and the marginal cost. To find out how
to calculate the slope of the isoprofit curve using calculus, see
LEIBNIZ 12.
EINSTEIN 1
Calculate the slope of the isoprofit curve. Suppose that a firm
is currently selling Q cars at a price P, with a marginal cost of
MC, and that P is greater than MC. If the firm increased its
quantity by 1, but kept the price the same, profit would increase
by (P-MC). The increase in profit would be (P-MC)/Q per car. So to
keep profit constant, the price of each car would need to decrease
by this amount.
This means that the isoprofit curve slopes downward. The slope
of the curve is the amount by which the price has to fall to keep
profit constant when Q rises by 1::
Slope = Fall in price, P = (P-MC)/Q
The same calculation works when MC is greater that P, except
that in this case an increase in price is required to keep profit
constant when quantity rises by 1. The isoprofit curve slopes
upward with slope equal to (MC-P)/Q.
In Figure 8 we have added the demand curve for this type of car.
What is the best choice of price and quantity for the manufacturer?
The only feasible choices are the points on or below the demand
curve, shown by the red-shaded area on the diagram. To maximize
profit the firm should choose the tangency point E, where it
reaches the highest possible isoprofit curve.
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coreecon | Curriculum Open-access Resources in Economics 14
Quantity of cars, Q
Pri
ce, m
argi
nal c
ost
($)
10,000
8,000
0
Isoprofit curve: $160,000Isoprofit curve: $56,000
Marginal cost
EP*
Q*
Demand curve
1000 120
Figure 8. The profit-maximising choice of price and quantity for
the car manufacturer.
The profit-maximising price and quantity are P* = $5,440 and Q*
= 32, and the corresponding profit is $56,000. LEIBNIZ 13 shows how
to find an equation for the firms profit-maximising price using
calculus, and demonstrates that the equation can be interpreted in
different ways.
DISCUSS 4: THE FIRMS CHOICE OF P AND Q
6. Suppose the firm sets P* = $5,440, but produces 50 cars
instead of 32. What will happen? How will its profit be
affected?
7. Is it feasible for the firm to choose Q* = 32 and P = $5,400?
What would happen to its profit in this case? (You should be able
to calculate it exactly.)
8. Suppose the firm decides to switch from P* = $5,440 and Q* =
32 to a higher price. Assuming that it chooses its output to make
as much profit as possible at the new price, explain how this will
affect: The quantity of cars produced. Total costs. Marginal cost.
The profit.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 15
7.4 GAINS FROM TRADE
when the firm sets its profit-maximising price P* = $5,440 and
sells Q* = 32 cars per day, the 32nd consumer, whose willingness to
pay is $5,440, is just indifferent between buying and not buying a
car, so that buyers gain from trade or surplus is equal to zero.
But other buyers were willing to pay more. You can see from Figure
9 that the 10th consumer, whose WTP is $7,200, makes a surplus of
$1,760, shown by the vertical red line in the diagram. The 15th
consumer has WTP $6,800 and hence a surplus of $1,360. To find the
total surplus obtained by consumers, we can add together the
surplus of each buyer: this is shown on the diagram by the
red-shaded trianglethe area between the demand curve and the line
where price is P*. This measure of the consumers gains from trade
is known as the consumer surplus.
10,000
8,000
0
Quantity of cars, Q
Isoprofit curve: $160,000Isoprofit curve: $56,000
Marginal cost
E
F
5,440
Q0
Pric
e, m
argi
nal c
ost (
$)
32
Demand curve
0 10 20 100 120
Q*
P*
Figure 9. Gains from trade.
You can think of this quantity as the difference between the
total that consumers actually paid at the price of $5,440, and the
total amount the seller could have collected if he had been able to
charge each consumer, separately, the maximum they would have been
willing to pay. Firms sometimes try to tailor their prices to
particular groups of consumersairlines charging last-minute
travellers higher fares, for exampleso as to capture some of the
surplus that would otherwise go to the buyers.
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coreecon | Curriculum Open-access Resources in Economics 16
Similarly, the firm makes what is called a producer surplus on
each car sold. The marginal cost of the 20th car is $2,000. By
selling it for $5,440 the firm gains $3,440, shown by a vertical
purple line in the diagram. To find the total producer surplus, we
add together the surplus on each car produced: this is the
purple-shaded area on the diagram.
Producer surplus is the difference between the firms daily
revenue when it sells 32 cars at $5,440, and the lesser amount it
would collect if consumers had all of the bargaining powerin which
case each buyer would bargain the price down to the firms marginal
cost of that particular car and the firm would get no surplus on
any car. (This is a hypothetical case; consumers in such a market
never have this type of bargaining power in practice.)
Recall that in Unit 5 we looked at voluntary exchange contracts
between Angela and Bart in which both parties gained; although the
division of the gains from exchange depended on bargaining power.
Here the consumer surplus for the 32 buyers, and the producer
surplus for the firm, are measures of their gains from trade in
this market. The car producer has more power than its consumers
because it is the only seller of this type of car. It can set a
high price and obtain a high share of the gains, knowing that
consumers with high valuations of the car have no alternative but
to accept. An individual consumer has no power to bargain for a
better deal because the firm has many other potential
customers.
Notice that the firm makes a surplus on every car produced,
including the 32nd and last one: the price is greater than the
marginal cost of making another car. This means that the allocation
of cars is not Pareto efficient. There are other consumers who
could be made better off, without reducing the firms profits,
because they are willing to pay more for a car than it would cost
the firm to produce it. So the potential gains from trade in the
market for this type of car have not been exhausted.
If the firm had chosen point F instead, where the marginal cost
line crosses the demand curve, producing Q0 cars and selling them
at a price equal to the marginal cost of the last car produced,
consumers who were willing to buy at the higher price would each
obtain a higher surplus due to the decrease in price, and
additional consumers would also obtain a surplus. This point
represents a Pareto efficient outcome, with no further potential
gains from trade. On the other hand the firm does better, at the
expense of consumers, by choosing point E.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 17
7.5 THE ELASTICITY OF DEMAND
the firm maximises profit by choosing the point where the slope
of the demand curve is equal to the slope of the isoprofit curve.
We can think of its decision in the same way as we did for the
student in Unit 3, who faced a trade-off between exam marks and
hours of free time. Here, the demand curve presents the firm with a
trade-off between price and quantity: the slope shows how much the
price will have to be lowered to sell another car. The slope of the
isoprofit curve represents the trade-off the firm is willing to
make: how much the price can be lowered if another car is sold,
without reducing profit. Profit is maximised at the point where the
two trade-offs are in balance.
So a firms choice of price and quantity depends on how steep the
demand curve is: in other words, how much consumers demand for a
good will change if the price changes. The price elasticity of
demand is a measure of the responsiveness of consumers to a price
change: it is defined as the percentage change in demand that would
occur in response to a 1% increase in price. For example, suppose
that when the price of a product increases by 10%, we observe a 5%
fall in the quantity sold. Then we can calculate the elasticity as
follows:
Elasticity = % change in demand/% change in price = 5/10 =
0.5
The price elasticity of demand is not the same as the slope of
the demand curve, but they are closely related. If the demand curve
is quite flat, the quantity changes a lot in response to a change
in price, so the elasticity is high. Conversely, a steep demand
curve corresponds to a low elasticity. In EINSTEIN 2 we show you
the precise relationship between elasticity and the slope of the
demand curve.
Figures 10 and 11 show how the elasticity of demand affects the
car manufacturers pricing decisions. Figure 10 represents a
situation of highly elastic demand. The demand curve is flat, so
small changes in price make a big difference to sales. The profit
maximising choice is point E. You can see that the profit marginthe
difference between the price and the marginal cost at this pointis
relatively small. This means that the quantity of cars it chooses
to make is not far below the quantity that would maximise total
gains from trade, at point F.
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coreecon | Curriculum Open-access Resources in Economics 18
EINSTEIN 2
Calculate the elasticity of demand. Suppose that, when the price
of a product increases by 5%, we observe a 10% fall in the quantity
sold. Then the elasticity of demand is 2 (10 divided by 5).
A flatter demand curve has a lower slope, so a higher
elasticity.
The diagram below shows how the elasticity of demand can be
calculated from the slope of the demand curve:
Price
Quantity
AP
Q
P
Q
At point A, the price is P and the quantity is Q.If the price
increases by P, the quantity falls by Q.
% change in P = 100 x P/P % change in Q = 100 x Q/Q
Elasticity at A =
=
=
% change in Q% change in P
Q / QP / PPQ P
Q
= PQ slope
1
Figure 11 shows the decision of a firm with the same costs of
car production, but inelastic demand for its product. In this case
the profit margin is high, and the quantity is low. When the price
is raised, many consumers are still willing to pay. The firm
maximises profits by exploiting this situation, obtaining a higher
share of the surplus, but the result is that fewer cars are sold
and the unexploited gains from trade are high.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 19
Pri
ce, m
argi
nal c
ost
($)
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Demand curve
Marginal cost
Isoprofit curve: $42,000
Profit margin
E
F
Quantity
0 10 20 30 40 50 60 70 80 90 100 110 120
Figure 10. A firm facing elastic demand.
Demand curve
Pri
ce, m
argi
nal c
ost
($)
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Marginal cost
Isoprofit curve: $104,000
Profitmargin
E
F
Quantity
0 10 20 30 40 50 60 70 80 90 100 110 120
Figure 11. A firm facing inelastic demand.
These examples illustrate that the lower the elasticity of
demand, the more the firm will raise the price above the marginal
cost, achieving a high profit margin. A low demand elasticity gives
the firm the power to raise the price without losing many
customers. EINSTEIN 3 shows you that the profit margin as a
proportion of the price, which we call the markup, is inversely
proportional to the elasticity of demand. To find out how to
calculate elasticities using calculus, see LEIBNIZ 14.
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coreecon | Curriculum Open-access Resources in Economics 20
EINSTEIN 3
We can find a formula for the size of the price markup chosen by
the firm, which shows that the markup is high when the elasticity
of demand is low:
From Figure 8 we can see that at the point chosen by the firm,
the slope of the isoprofit curve is equal to the slope of the
demand curve. We know that the slope of the demand curve is related
to the price elasticity of demand: elasticity = P/Q x 1/slope.
Rearranging this formula: slope of demand curve = P/Q x
1/elasticity
We have also calculated: slope of isoprofit curve = (P-MC)/Q
When the two slopes are equal: (P-MC)/Q = P/Q x 1/elasticity
Rearranging this gives us: (P-MC)/P = 1/elasticity
(P-MC)/P is the difference between price and marginal cost as a
proportion of the price, which is a measure of the markup. So we
have shown that the firms markup is inversely proportional to the
elasticity of demand.
7.6 USING DEMAND ELASTICITIES IN GOVERNMENT POLICY
measuring elasticities of demand is useful to policy makers as
well as firms choosing prices. If the government puts a tax on a
particular good, the tax will raise the price paid by consumers, so
the effect of the tax will depend on the elasticity of demand. If
demand is highly elastic, the tax will reduce sales. That may be
what the government intends: for example, governments use taxes on
tobacco to discourage smoking because it is harmful to health. But
if a tax causes a large fall in sales, it also reduces the
potential tax revenue. This suggests that a government wishing to
raise tax revenue should choose to tax products with inelastic
demand.
Several countries, including Denmark and France, have recently
introduced taxes intended to reduce the consumption of unhealthy
food and drink. A 2014 international study found worrying increases
in adult and childhood obesity since 1980. In 2013, 37% of men and
38% of women worldwide were overweight or obese.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 21
In North America, the figures are 70% and 61%, but the obesity
epidemic does not only affect the richest countries; the
corresponding rates were 59% and 66% in the Middle East and North
Africa.
Matthew Harding and Michael Lovenheim used detailed data on the
food purchases of US consumers to estimate elasticities of demand
for different types of food, to investigate the effects of food
taxes. They divided food products into 33 categories and used a
model of consumer decision-making to examine how changes in their
prices would change the share of each category in consumers
expenditure on food, and hence the nutritional composition of the
diet, taking into account that the change in the price of any
product would change the demand for that product and other products
too. The table below shows the prices and elasticities for some of
the categories.
You can see in Figure 12 that the demand for lower calorie milk
products is the most price responsive. If their price increased by
10%, the quantity purchased would fall by 19.72%. Demand for snacks
and candy is quite inelastic, which suggests that it may be
difficult to deter consumers from buying them.
CATEGORY TYPE CALORIES PER SERVINGPRICE PER
100G ($)
TYPICAL SPENDING PER WEEK
($)
PRICE ELASTICITY OF DEMAND
1 Fruit and vegetables 660 0.38 2.00 1.128
2 Fruit and vegetables 140 0.36 3.44 0.830
15 Grain, Pasta, Bread 1540 0.38 2.96 0.854
17 Grain, Pasta, Bread 960 0.53 2.64 0.292
28 Snacks, Candy 433 1.13 4.88 0.270
29 Snacks, Candy 1727 0.68 7.60 0.295
30 Milk 2052 0.09 2.32 1.793
31 Milk 874 0.15 1.44 1.972
Figure 12. Price elasticities of demand for different types of
food.
Source: Extracted from Harding, M., and Lovenheim, M. 2013. The
effect of prices on nutrition: comparing the impact of product-and
nutrient-specific taxes. SIEPR Discussion Paper No. 13-023:
LINK.
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coreecon | Curriculum Open-access Resources in Economics 22
DISCUSS 5: ELASTICITY AND EXPENDITURE
The table also shows the spending per week in each category of a
US consumer whose total expenditure on food is $80, with typical
spending patterns across food categories.
1. Suppose that the price of category 30, high-calorie milk
products, increased by 10%: By what percentage would his demand for
high-calorie milk products fall? Calculate the quantity he
consumes, in grams, before and after the price
change. Calculate his total expenditure on high-calorie milk
products before and after
the price change. You should find that expenditure falls.2. Now
choose a category for which the price elasticity is less than 1,
and repeat the
calculations. In this case you should find that expenditure
rises.
Harding and Lovenheim examined the effects of 20% taxes on
sugar, fat and salt. A 20% sugar tax, for example, would increase
the price of a product that contains 50% sugar by 10%. A sugar tax
was found to have the most positive effect on nutrition. It would
reduce sugar consumption by 16%, fat by 12%, salt by 10%, and
calorie intake by 19% .
DISCUSS 6: FOOD TAXES AND HEALTH
Food taxes intended to shift consumption towards a healthier
diet are controversial. Some people think that individuals should
make their own choices, and if they prefer unhealthy products, the
government should not interfere. But what if you make dietary
choices you subsequently regret? You prefer to eat healthy food,
but are sometimes weak-willed, acting in the short-term against
your own long-term preferences. Do you think this would justify
taxes on sugar, fat, and salt?
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 23
7.7 MONOPOLY POWER AND COMPETITION
our analysis of the firms pricing decisions might be applied to
any firm producing and selling a product that is in some way
different from that of any other firm. In the 19th century the
French economist Augustin Cournot carried out a similar analysis
using the example of bottled water from a mineral spring which has
just been found to possess salutary properties possessed by no
other. Cournot referred to this as a case of monopolya market in
which there is only one seller. He showed, as we have done, that
the firm would set a price greater than the marginal production
cost.
PAST ECONOMISTS
AUGUSTIN COURNOT
Augustin Cournot (1801-1877) was a French economist, now most
famous for his model of oligopoly (a market with a small number of
firms). Cournots 1838 book Recherches sur les Principes
Mathmatiques de la Thorie des Richesses (Research on the
Mathematical Principles of the Theory of Wealth) introduced a new
mathematical approach to economics, although he feared it would
draw on me the condemnation of theorists of repute. Cournots work
influenced other 19th century economists such as Marshall and
Walras, and established the basic principles we still use to think
about the behaviour of firms. Although he used algebra rather than
diagrams, Cournots analysis of demand and profit maximisation is
very similar to ours.
While the definition of monopoly seems straightforward, it
really depends on how we define the relevant market. There may be
only one seller of the water from a particular spring, but many
sellers in the market for bottled water. We usually reserve the
label monopoly for cases where there are no close substitutesno
similar products available from other firms. The domestic water
supply, for example, is typically a regional monopoly: residents
can obtain water only from one local supply company.
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coreecon | Curriculum Open-access Resources in Economics 24
We think of cars, and bottled water, as examples of
differentiated products rather than monopoly. So far, our analysis
of pricing applies to both. But, unlike the monopolist, the
producer of a differentiated product may face competition from
other firms producing close substitutes for its own brand.
Markets with differentiated products reflect differences in the
preferences of consumers. People who want to buy a car are looking
for different combinations of characteristics. A consumers
willingness to pay for a particular model will depend not only on
its characteristics, but also on the characteristics and prices of
similar types of car sold by other firms.
For example, Figure 13 shows the purchase prices of a three-door
1.0 litre hatchback in the UK in January 2014 that a consumer could
find on a price comparison web site:
FORD FIESTA
VAUXHALL CORSA
PEUGEOT 208
TOYOTA IQ
11,917
11,283
10,384
11,254
PRICE
Figure 13. Car purchase prices in the UK, January 2014.
Source: Autotrader.com
Although the four cars are similar in their main
characteristics, the website compares them on 75 other features,
many of which differ between them.
When consumers are able to choose between several quite similar
cars, the demand curve for each of these cars is likely to be quite
flat. If the price of the Ford Fiesta, for example, were to rise,
demand would fall because people would choose to buy one of the
other brands instead. Conversely if the price of the Ford Fiesta
were to fall, demand would increase because consumers would be
attracted away from the other cars. The more similar the other cars
are to a Ford Fiesta, the more responsive
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 25
consumers will be to price differences. Only those with the
highest brand loyalty to Ford, and those with a strong preference
for a characteristic of the Ford that other cars do not possess,
would fail to respond. As we saw in the previous section, highly
elastic demand means that the firm will have a relatively low price
and profit margin.
In contrast, the manufacturer of a very specialised type of car,
quite different from any other brand in the market, faces little
competition and hence less elastic demand. It can set a price well
above marginal cost without losing customers. Such a firm is
earning high rentseconomic profits over and above its costs of
production similar to the first firm to introduce a new technology
that we saw in Unit 2. The rents arise from its position as the
only supplier of this type of car.
We expect a monopolist, with no competitors, to face relatively
inelastic demand. In its relationship with potential consumers it
has sufficient bargaining power to make a take-it-or-leave-it offer
of a high price. Although any firm producing a differentiated
product behaves in the same way as a monopolist when setting its
price, it has less monopoly power: that is, less ability to benefit
from setting a high price. The more it is exposed to competition
from substitutable products, the more elastic will be its demand
curve, and the lower its profit margin and rents.
7.8 THE PROBLEM OF MONOPOLY POWER
the analysis in the previous section helps to explain why
policymakers may be concerned about cases of monopoly: a monopolist
is able to set high prices, and make high profits, at the expense
of consumers. Potential consumer surplus is lost because few
consumers buy, and because those who do buy pay a high price.
The way in which the policymaker should respond to this
situation will depend on the reason for the existence of a
monopoly. If one firm is becoming dominant in a market, governments
may intervene to promote competition. In 2000 the European
Commission prevented the proposed merger of Volvo and Scania on the
grounds that the merged firm would have a dominant position in the
heavy trucks market in Ireland and the Nordic countries,
particularly in Sweden where the combined market share of the two
firms was 91%.
A particular cause for concern is that when there are only a few
firms in the market they may form a cartel: a group of firms that
collude to keep the price high, rather than competing with each
other. By working together they can increase profits by behaving as
a monopoly. A well-known example is OPEC, an association of
oil-producing countries who jointly agree to limit production to
maintain a high oil price. The actions of the OPEC cartel played a
major role in sustaining high oil prices
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coreecon | Curriculum Open-access Resources in Economics 26
at a global level following the sharp increase in oil prices in
1973 and again in 1979. We return to study the effect of the oil
price shocks on inflation and unemployment in Unit 14.
While cartels between private firms are illegal in many
countries, firms often find ways to cooperate in the setting of
prices so as to maximise profits. Policy to limit monopoly power
and prevent cartels is known as competition policy, or antitrust
policy in the US. In a famous antitrust case, the US Department of
Justice accused Microsoft of behaving anti-competitively by
bundling its own Internet Explorer web-browser with its Windows
operating system.
As the Microsoft example illustrates, dominant firms may exploit
their position in ways other than setting high prices. In the 1920s
an international group of companies making electric light bulbs,
including Philips, Osram and General Electric, formed a cartel that
agreed a policy of planned obsolescence: to reduce the lifetime of
their bulbs to 1,000 hours, so that consumers would have to replace
them more quickly. The growth of Walmart, the largest retailer in
the world, has been controversial, but not because of its prices;
instead it has been accused of reducing wages in the locality of
its stores, driving smaller retailers out of the market, and using
its bargaining power to reduce the profitability of its
suppliers.
DISCUSS 7: MULTINATIONALS V. INDEPENDENT RETAILERS
Imagine that you are a local politician in a town where a
multinational retailer is planning to build a new superstore. A
local campaign is protesting that it will drive small independent
retailers out of business, and thereby reduce consumer choice and
change the character of the area. Supporters of the plan counter
that this will only happen if consumers prefer the supermarket.
Which side are you on?
Competition policy is not a solution in all cases. In domestic
utilities such as water, electricity and gas, there are high fixed
costs of providing the supply network, irrespective of the quantity
demanded by consumers. The average cost of producing a unit of
water, electricity or gas will be very high unless the firm
operates at a large scale. If a single firm can supply the whole
market at lower average cost than two firms, the industry is said
to be a natural monopoly.
In the case of a natural monopoly, a policymaker may choose to
regulate the firms activities, aiming to increase consumer surplus
by limiting the firms discretion over prices. An alternative is
public ownership. The majority of water supply companies
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 27
around the world are owned by the public sector, although in
England and Wales in 1989, and in Chile in the 1990s, the entire
water industry was privatised and regulated by a public sector
agency.
7.9 PRODUCT SELECTION, INNOVATION AND ADVERTISING
the profits that a firm can achieve depend on the demand curve
for its product, which in turn depends on the preferences of
consumers and the competition from other firms. But the firm may be
able to move the demand curve to increase profits by its selection
of products, or through advertising.
When deciding what goods to produce, the firm would ideally like
to find a product that is both attractive to consumers and has
different characteristics from the products sold by other firms. In
this case demand would be highmany consumers would wish to buy it
at each priceand inelastic. Of course, this is not likely to be
easy: a firm wishing to make a new breakfast cereal, or type of
car, knows that there are many brands on the market already. But
technological innovation may provide opportunities to get ahead of
competitors. For some years after Toyota developed the first
mass-produced hybrid car, the Prius, in 1997, there were very few
comparable cars available. Toyota effectively monopolised the
hybrid market. By 2013 there were several competing brands, but the
Prius remained the market leader, with more than 50% of hybrid
sales.
If a firm has invented or created a new product, it may be able
to prevent competition altogether by claiming exclusive rights to
produce it, using patent or copyright laws. This kind of legal
protection of monopoly may help to provide incentives for research
and development of new products, but at the same time limits the
gains from trade. In Unit 20 we analyse intellectual property
rights in more detail.
Advertising is another strategy firms can use to influence
demand: it is widely used by both car manufacturers and breakfast
cereal producers. When products are differentiated, the firm can
use advertising to inform consumers about the existence and the
characteristics of its product, to attract them away from its
competitors, and to create brand loyalty.
According to the analyst Schonfeld and Associates, advertising
on breakfast cereals in the US is about 5.5% of total sales
revenueabout three and a half times higher than the average for
manufactured products. The data in Figure 14 is for the
highest-selling 35 breakfast cereal brands sold in the Chicago area
in 1991 and 1992. The graph shows the relationship between market
share and quarterly expenditure on advertising. If you investigated
the breakfast cereals market more closely, you
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coreecon | Curriculum Open-access Resources in Economics 28
would see that market share is not closely related to price. But
it is clear from Figure 14 that the brands with the highest share
are also the ones that spend the most on advertising. The economist
Matthew Shum analysed cereal purchases in Chicago using this data,
and showed that advertising was more effective than price discounts
in stimulating demand for a brand. Since the most well-known brands
were also the ones spending most on advertising, he concluded that
its main function was not to inform consumers about the product,
but rather to increase brand loyalty, and encourage consumers of
other cereals to switch.
6
5
4
3
2
1
0
Quarterly national advertising expenditure, $m
Mar
ket s
hare
%
Corn Flakes
Cheerios
Frosted Flakes
Grape Nuts
Raisin BranQuaker Oats
0 1 2 3 4 5 6 7 8
Figure 14. Advertising expenditure and market share of breakfast
cereals, Chicago, 1991-92.
Source: Shum, M. 2004. Does Advertising Overcome Brand Loyalty?
Evidence from the Breakfast Cereals Market. Journal of Economics
and Management Strategy, 13(2), pp. 241-272, Fig 1.
7.10 CONCLUSION
we have studied how firms producing differentiated products
choose the price, and the quantity of output to produce, to
maximise their profit. These decisions depend on the demand curve
for the productespecially the elasticity of demandand the cost
structure for producing it.
But as Figure 15 shows, firms make other decisions that
influence the demand curve and the cost structure. The firm chooses
the characteristics of its product through product innovation,
aiming to attract consumers and differentiate itself further from
its competitors, thereby reducing the elasticity of demand. And as
we saw in Unit 2,
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 29
innovation in the production process may enable it to reduce its
costs. If the firm can innovate successfully it can earn rents; at
least in the short term until others catch up. Further innovation
may be needed if it is to stay ahead. Advertising can increase
demand and reduce its elasticity. As we saw in the previous unit,
the firm sets the wage; and as we will see in Unit 21, the firm
also spends to influence taxes and environmental regulation.
Figure 15. The firms decisions.
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coreecon | Curriculum Open-access Resources in Economics 30
UNIT 7 KEY POINTS
1. The product demand curve tells you how many units consumers
will buy at each price.
2. The firms marginal cost is the addition to total cost of
making one extra unit of output.
3. In markets where products are differentiated
Each firm chooses its price and quantity from the feasible set
given the demand for its own brand; the profit-maximising point is
where the demand curve touches the highest isoprofit curve.
The firm sets a price greater than its marginal cost, which
means that all the potential gains from trade are not realised.
The lower is the elasticity of demand (steeper demand curve),
the higher is the firms price relative to its marginal cost, and
the higher is its profit margin.
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UNIT 7 | THE FIRM AND ITS CUSTOMERS 31
UNIT 7: READ MORE
7.1 THE PRODUCT DEMAND CURVE
The Law of DemandEvans, G. H. 1967. The Law of Demandthe Roles
of Gregory King and Charles Davenant. The Quarterly Journal of
Economics, 81 (3): pp. 483-492.
7.2 PRODUCTION: THE FIRMS COST FUNCTION
Economies of scale and the theory of priceThis article from The
Economist explains more about economies of scale and scope:
LINK.The Economist. 2008. Economies of scale and scope, 20
October.For an interesting discussion of costs, see Chapter 7 of
George Stiglers book, available online: LINK.Stigler, G. 1987. The
Theory of Price. New York: Macmillan.
7.6 USING DEMAND ELASTICITIES IN GOVERNMENT POLICY
Prices, nutrition and obesityThis blog illustrates one reaction
to Matthew Harding and Michael Lovenheims research: LINK.Huffington
Post. 2014. Theres An Easy Way To Fight Obesity, But Conservatives
Will HATE It, 7 January.Harding and Lovenheims original
article:Harding, M. and Lovenheim, M. 2014. The effect of prices on
nutrition: comparing the impact of product-and nutrient-specific
taxes (No. w19781). National Bureau of Economic Research.
7.8 THE PROBLEM OF MONOPOLY POWER
US v. MicrosoftRichard Gilbert and Michael Katz explain the
source and strength of Microsofts power: LINK.Gilbert, R. J. and
Katz, M. L. 2001. An economists guide to US v. Microsoft. Journal
of Economic Perspectives, pp. 25-44.
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coreecon | Curriculum Open-access Resources in Economics 32
Market powerJohn Vickers describes the different ways firms can
exploit and maintain a dominant position in the market.Vickers, J.
1996. Market power and inefficiency: A contracts perspective.
Oxford Review of Economic Policy, 12(4), pp. 11-26.The causes and
consequences of Walmarts growth are discussed by Emel Basker:
LINK.Basker, E. 2007. The causes and consequences of Wal-Marts
growth. The Journal of Economic Perspectives, pp. 177-198.The
history of the light-bulb cartel is explained in this student blog:
LINK.Economics Student Society of Australia. 2012. Planned
Obsolescence: The Light Bulb Conspiracy, 12 September.
7.9 PRODUCT SELECTION, INNOVATION AND ADVERTISING
The structure of strategyJohn Kay discusses the business
strategies that successful companies use: LINK.Kay, J. 1993. The
Structure of Strategy. Business Strategy Review, 4: pp. 1737.
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