THEMES AND CAPSTONE UNITS
21: Innovation
22: Politics and policy
UNIT 7
THE FIRM AND ITS
CUSTOMERS
HOW A PROFIT-MAXIMIZING FIRM PRODUCING A
DIFFERENTIATED PRODUCT INTERACTS WITH ITS
CUSTOMERS
• Firms producing differentiated products choose price and quantity
to maximize their profits, taking into account the product demand curve
and the cost function.
• Technological and cost advantages of large-scale production favour large
firms.
• The responsiveness of consumers to a price change is measured by the
elasticity of demand, which affects the firm’s price and profit margin.
• The gains from trade are shared between consumers and firm owners,
but prices above marginal cost cause market failure and deadweight loss.
• Firms can increase profit through product selection and advertising.
Those with fewer competitors can achieve higher profit margins, and
monopoly rents.
• Economic policymakers use elasticities of demand to design tax policies,
and reduce firms’ market power through competition policy.
Ernst F. Schumacher’s Small is Beautiful, published in 1973, advocated
small-scale production by individuals and groups in an economic system
designed to emphasize happiness rather than profits. In the year the book
was published, the firms Intel and FedEx each employed only a few
thousand people in the US. Fifty years later, Intel employed around 110,000
people, and FedEx 245,000. Walmart had around 3,500 employees in 1973.
In 2021 it employed 2.3 million.
Most firms are much smaller than this, but in all rich economies, most
people work for large firms. In the US, 52% of private-sector employees
work in firms with at least 500 employees. Firms grow because their
owners can make more money if they expand, and people with money to
invest get higher returns from owning stock in large firms. Employees in
Ernst F. Schumacher. 1973. Small Is
Beautiful: Economics as If People
Mattered (https://tinyco.re/
3749799). New York, NY:
HarperCollins. Note: link to first 80
pages only.
Ford advertisement
263
large firms are also paid more. Figure 7.1 shows the growth of some highly
successful US firms.
What strategies can firms use to prosper and grow like the ones in
Figure 7.1? The story of the British retailer Tesco, founded in 1919 by Jack
Cohen, suggests one answer.
‘Pile it high and sell it cheap,’ was Jack Cohen’s motto. He started as a
street trader in the East End of London, and opened his first store 10 years
later. Today, £1 in every £9 spent in a shop in the UK is spent in a Tesco
store, and the company expanded worldwide in the 1990s. In 2014 Tesco
had 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 maximize its profits: even though the profit on each item is
small, the low price may attract so many customers that total profit is high.
Other firms 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, Tesco’s operating profit
per unit was between 6.0% and 6.5%.
A firm’s success depends on more than getting the price right. Product
choice and ability to attract customers, produce at lower cost and at a
higher quality than their competitors all matter. They also need to be able
to recruit and retain employees who can make all these things happen.
Figure 7.2 illustrates key decisions that a firm makes. In this unit, we will
focus particularly on how a firm chooses the price of a product, and the
quantity to produce. This will depend on the demand it faces—that is, the
willingness of potential consumers to pay for its product—and its produc-
tion costs.
The demand for a product will depend on its price, and the costs of pro-
duction may depend on how many units are produced. But a firm can
actively influence both consumer demand and costs in more ways than
through price and quantity. As we saw in Unit 2, innovation may lead to
new and attractive products, or to lower production costs. If the firm can
innovate successfully it can earn economic rents—at least in the short term
Jack Cohen, the founder of Tesco,
began as a street market trader in
the East End of London. The
traders would gather at dawn each
day and, at a signal, race to their
favourite stall site, known as a
pitch. Cohen perfected the
technique of throwing his cap to
claim the most desirable pitch. In
the 1950s, Cohen began opening
supermarkets on the US model,
adapting quickly to this new style
of operation. Tesco became the UK
market leader in 1995, and now
employs almost half a million
people in Europe and Asia.
Today Tesco’s pricing strategy
aims to appeal to all segments of
the market, labelling some of its
own-brand products as Finest, and
others as Value. The BBC Money
Programme summarized the three
Tesco commandments as ‘be
everywhere’, ‘sell everything’, and
‘sell to everyone’.
Walmart
McDonald's
Ford
FedEx
Proctor and Gamble
Intel
Dell
Amazon
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
19
00
19
10
19
20
19
30
19
40
19
50
19
60
19
70
19
80
19
90
20
00
20
10
20
20
Year
N
um
be
ro
fe
m
pl
oy
ee
s
Figure 7.1 Firm size in the US: Number of employees (1900–2021).
View this data at OWiD https://tinyco.re/
8927352
Erzo G. J. Luttmer. 2011. ‘On the
Mechanics of Firm Growth’. The Review
of Economic Studies 78 (3): pp. 1042–68.
UNIT 7 THE FIRM AND ITS CUSTOMERS
264
demand curve The curve that gives
the quantity consumers will buy at
each possible price.
until others catch up. Further innovation may be needed if it is to stay
ahead. Advertising can increase demand. And as we saw in Unit 6, the firm
sets the wage, which is an important component of its cost. As we will see
in later units, the firm also spends to influence taxes and environmental
regulation in order to lower its production costs.
7.1 BREAKFAST CEREAL: CHOOSING A PRICE
To decide what price to charge, a firm needs information about demand:
how much potential consumers are willing to pay for its product. Figure 7.3
shows the demand curve for Apple-Cinnamon Cheerios, a ready-to-eat
breakfast cereal introduced by the company General Mills in 1989. In 1996,
Jerry Hausman, an economist, used data on weekly sales of family breakfast
cereals in US cities to estimate how the weekly quantity of cereal that
customers in a typical city would wish to buy would vary with its price per
pound (there are 2.2 pounds in 1 kg). For example, you can see from Figure
7.3 that if the price were $3, customers would demand 25,000 pounds of
Apple-Cinnamon Cheerios. For most products, the lower the price, the
more customers wish to buy.
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?
Expenditure
on innovation
Sets the
price
Quantity
sold
Expenditure to influence
taxes and other public policies
Expenditure
on advertising
Sets the
wage
Cost
curve
Demand
curve
What to
produce
How to
produce
Profit Hiring
Figure 7.2 The firm’s decisions.
7.1 BREAKFAST CEREAL: CHOOSING A PRICE
265
‘Willingness to Pay for a Flight in
Space’ (https://tinyco.re/7817145).
Statista. Updated 20 October 2011.
HOW ECONOMISTS LEARN FROM FACTS
Estimating demand curves using surveys
Jerry Hausman used data on cereal purchases to estimate the demand
curve for Apple-Cinnamon Cheerios. Another method, particularly
useful for firms introducing completely new products, is a consumer
survey. Suppose you were investigating the potential demand for space
tourism. You could try asking potential consumers:
‘How much would you be willing to pay for a 10-minute flight in
space?’
But they may find it difficult to decide, or worse, they may lie if they
think their answer will affect the price eventually charged. A better way
to find out their true willingness to pay might be to ask:
‘Would you be willing to pay $1,000 for a 10-minute flight in space?’
In 2011, someone did this, so now we know the consumer demand
for space flight.
Whether the product is cereal or space flight, the method is the same.
If you vary the prices in the question, and ask a large number of con-
sumers, you would be able to estimate the proportion of people willing
to pay each price. Hence you can estimate the whole demand curve.
Demand curve
0
2
4
6
8
0 20,000 40,000 60,000 80,000
Quantity of Cheerios, Q (pounds)
Pr
ic
e,
P
(d
ol
la
rs
pe
rp
ou
nd
)
Figure 7.3 Estimated demand for Apple-Cinnamon Cheerios.
Adapted from Figure 5.2 in Jerry A.
Hausman. 1996. ‘Valuation of New
Goods under Perfect and Imperfect
Competition’ (https://tinyco.re/1626988).
In The Economics of New Goods,
pp. 207–248. Chicago, IL: University of
Chicago Press.
UNIT 7 THE FIRM AND ITS CUSTOMERS
266
You need to consider how the decision will affect your profits (the dif-
ference between sales revenue and production costs). Suppose that the unit
cost (the cost of producing each pound) of Apple-Cinnamon Cheerios is $2.
To maximize your profit, you should produce exactly the quantity you
expect to sell, and no more. Then revenue, costs, and profit are given by:
So we have a formula for profit:
Using this formula, you could calculate the profit for any choice of price
and quantity and draw the isoprofit curves, as in Figure 7.4. Just as indiffer-
ence curves join points in a diagram that give the same level of utility,
isoprofit curves join points that give the same level of total profit. We can
think of the isoprofit curves as the firm’s indifference curves: the firm is
indifferent between combinations of price and quantity that give you the
same profit.
QUESTION 7.1 CHOOSE THE CORRECT ANSWER(S)
A firm’s cost of production is £12 per unit of output. If P is the price of
the output good and Q is the number of units produced, which of the
following statements is correct?
Point (Q, P) = (2,000, 20) is on the isoprofit curve representing the
profit level £20,000.
Point (Q, P) = (2,000, 20) is on a lower isoprofit curve than point (Q,
P) = (1,200, 24).
Points (Q, P) = (2,000, 20) and (4,000, 16) are on the same isoprofit
curve.
Point (Q, P) = (5,000, 12) is not on any isoprofit curve.
QUESTION 7.2 CHOOSE THE CORRECT ANSWER(S)
Consider a firm whose unit cost (the cost of producing one unit of
output) is the same at all output levels. Which of the following state-
ments are correct?
Each isoprofit curve depicts the firm’s profit for different outputs for
a given price of the output good.
Isoprofit curves can be upward-sloping when at high profit levels.
Every price-quantity combination lies on an isoprofit curve.
Isoprofit curves slope downward when the price is above the unit
cost.
7.1 BREAKFAST CEREAL: CHOOSING A PRICE
267
To achieve a high profit, you would like both price and quantity to be as
high as possible, but you are constrained by the demand curve. 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 demand curve determines what is feasible. Figure 7.5a shows the
isoprofit curves and demand curve together. You face a similar problem to
Alexei, the student in Unit 3, who wanted to choose the point in his feasible
set where his utility was maximized. You want to choose a feasible price and
quantity combination that will maximize your profit.
Your best strategy is to choose point E in Figure 7.5a: you should
produce 14,000 pounds of cereal, and sell it at a price of $4.40 per pound,
making $34,000 profit. Just as in the case of Alexei in Unit 3, your optimal
combination of price and quantity involves balancing two trade-offs. As
manager, we have assumed that you care about profit, rather than any
particular combination of price and quantity.
0
1
2
3
4
5
6
7
8
9
10
0 20,000 40,000 60,000 80,000
Quantity of Cheerios, Q (pounds)
Pr
ic
e,
P
(d
ol
la
rs
pe
rp
ou
nd
)
Isoprofit curve: $60,000
Isoprofit curve: $34,000
Isoprofit curve: $23,000
Isoprofit curve: $10,000
Isoprofit curve: $0
Figure 7.4 Isoprofit curves for the production of Apple-Cinnamon Cheerios. Note:
Isoprofit data is illustrative only, and does not reflect the real-world profitability of
the product.
1. Isoprofit curves
The graph shows a number of isoprofit
curves for Cheerios.
2. Isoprofit curve: $60,000
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 curve shows all the possible ways
of making $60,000 profit.
3. Isoprofit curve: $34,000
The $34,000 isoprofit curve shows all
the combinations of P and Q for which
profit is equal to $34,000.
4. Isoprofit curve: $23,000
The isoprofit curves nearer to the origin
correspond to lower levels of profit.
5. Isoprofit curve: $10,000
The cost of each pound of Cheerios is
$2, so profit = (P − 2) × Q. This means
that isoprofit curves slope downward.
To make a profit of $10,000, P would
have to be very high if Q was less than
8,000. But if Q = 80,000 you could make
this profit with a low P.
6. Zero profits
The horizontal 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.
UNIT 7 THE FIRM AND ITS CUSTOMERS
268
marginal rate of substitution (MRS)
The trade-off that a person is
willing to make between two
goods. At any point, this is the slope
of the indifference curve. See also:
marginal rate of transformation.
marginal rate of transformation
(MRT) The quantity of some good
that must be sacrificed to acquire
one additional unit of another
good. At any point, it is the slope of
the feasible frontier. See also: mar-
ginal rate of substitution.
• 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.
These two trade-offs balance at the profit-maximizing choice of P and Q.
The manager at General Mills probably didn’t think about the decision
in this way.
Perhaps the price was chosen more by trial and error, informed by past
experience and market research. But we expect that a firm will find its way,
somehow, to a profit-maximizing price and quantity. The purpose of our
economic analysis is not to model the manager’s thought process, but to
understand the outcome, and its relationship to the firm’s cost and con-
sumer demand.
Feasible set
E
0
1
2
3
4
5
6
7
8
9
10
0 20,000 40,000 60,000 80,000
Quantity of Cheerios, Q (pounds)
Pr
ic
e,
P
(d
ol
la
rs
pe
rp
ou
nd
)
Isoprofit curve: $60,000
Isoprofit curve: $34,000
Isoprofit curve: $10,000
Isoprofit curve: $0
Demand curve
Figure 7.5a The profit-maximizing choice of price and quantity for Apple-Cinnamon
Cheerios.
Demand curve data from Jerry A.
Hausman. 1996. ‘Valuation of New
Goods under Perfect and Imperfect
Competition’. In The Economics of New
Goods, pp. 207–248. Chicago, IL: Univer-
sity of Chicago Press.
1. The profit-maximizing choice
The manager would like to choose a
combination of P and Q on the highest
possible isoprofit curve in the feasible
set.
2. Zero profits
The horizontal 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.
3. Profit-maximizing choices
The manager would choose a price and
quantity corresponding to a point on
the demand curve. Any point below the
demand curve would be feasible, such
as selling 8,000 pounds of cereal at a
price of $3, but you would make more
profit if you raised the price.
4. Maximizing profit at E
You reach the highest possible isoprofit
curve while remaining in the feasible
set by choosing point E, where the
demand curve is tangent to an isoprofit
curve. The manager should choose
P = $4.40, and Q = 14,000 pounds.
7.1 BREAKFAST CEREAL: CHOOSING A PRICE
269
Even from an economist’s point of view, there are other ways to think
about profit maximization. The lower panel of Figure 7.5b shows how
much profit would be made at each point on the demand curve.
The graph in the lower panel is the profit function: it shows the profit
you would achieve if you chose to produce a quantity, Q, and set the highest
price that would enable you to sell that quantity, according to the demand
function. And it tells us, again, that you would achieve the maximum profit
of $34,000 with Q = 14,000 pounds of cereal.
E
0
1
2
3
4
5
6
7
8
9
10
0 20,000 40,000 60,000 80,000
Pr
ic
e,
P
(d
ol
la
rs
pe
rp
ou
nd
)
Isoprofit curve: $60,000
Isoprofit curve: $34,000
Isoprofit curve: $10,000
Isoprofit curve: $0
Demand curve
20,000 40,000 60,000 80,000
−15,000
0
15,000
30,000
45,000
Quantity of Cheerios, Q (pounds)
Pr
of
it
($
)
Figure 7.5b The profit-maximizing choice of price and quantity for Apple-Cinnamon
Cheerios.
Demand curve data from Jerry A.
Hausman. 1996. ‘Valuation of New
Goods under Perfect and Imperfect
Competition’ (https://tinyco.re/1626988).
In The Economics of New Goods,
pp. 207–248. Chicago, IL: University of
Chicago Press.
1. The profit function
The firm can calculate its profit at each
point on the demand curve.
2. Profit at low quantities
When the quantity is low, so is the
profit.
3. Increasing profits
As quantity increases, profit rises until…
4. Maximum profits
… profit reaches a maximum at E.
5. Falling profits
Beyond E the profit falls.
6. Zero profits
Profit falls to zero when the price is
equal to the unit cost, $2.
7. Negative profits
To sell a very high quantity, the price
has to be lower than the unit cost, so
profit is negative.
UNIT 7 THE FIRM AND ITS CUSTOMERS
270
QUESTION 7.3 CHOOSE THE CORRECT ANSWER(S)
The table represents market demand Q for a good at different prices P.
Q 100 200 300 400 500 600 700 800 900 1,000
P £270 £240 £210 £180 £150 £120 £90 £60 £30 £0
The firm’s unit cost of production is £60. Based on this information,
which of the following is correct?
At Q = 100, the firm’s profit is £20,000.
The profit-maximizing output is Q = 400.
The maximum profit that can be attained is £50,000.
The firm will make a loss at all outputs of 800 and above.
EXERCISE 7.1 CHANGES IN THE MARKET
Draw diagrams to show how the curves in Figure 7.5a (page 269) would
change in each of the following cases:
1. A rival company producing a similar brand slashes its prices.
2. The cost of producing Apple-Cinnamon Cheerios rises to $3 per pound.
3. A well-publicized government study shows that General Mills’ products
are healthier than other breakfast cereals.
To make sketching the curves easier, assume the demand curve is linear.
In each case, can you say what would happen to the price and the profit?
•7.2 ECONOMIES OF SCALE AND THE COST
ADVANTAGES OF LARGE-SCALE PRODUCTION
Why have firms like Walmart, Intel and FedEx grown so large? An import-
ant reason why a large firm may be more profitable than a small firm is that
the large firm produces its output at lower cost per unit. This may be
possible for 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 or
acquiring the necessary patents or other intellectual property rights
(IPR) 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.
7.2 ECONOMIES OF SCALE
271
economies of scale These occur when doubling all of the
inputs to a production process more than doubles the output.
The shape of a firm’s long-run average cost curve depends both
on returns to scale in production and the effect of scale on the
prices it pays for its inputs. Also known as: increasing returns to
scale. See also: diseconomies of scale.
diseconomies of scale These occur when doubling all of the
inputs to a production process less than doubles the output.
Also known as: decreasing returns to scale. See also: economies
of scale.
constant returns to scale These occur when doubling all of the
inputs to a production process doubles the output. The shape
of a firm’s long-run average cost curve depends both on returns
to scale in production and the effect of scale on the prices it
pays for its inputs. See also: increasing returns to scale,
decreasing returns to scale.
ECONOMIES AND DISECONOMIES OF SCALE
If we increase all inputs by a given proportion, and it:
• increases output more than proportionally, then the techno-
logy is said to exhibit increasing returns to scale in
production or economies of scale,
• increases output less than proportionally, then the techno-
logy exhibits decreasing returns to scale in production or
diseconomies of scale,
• increases output proportionally, then the technology
exhibits constant returns to scale in production.
research and development
Expenditures by a private or public
entity to create new methods of
production, products, or other eco-
nomically relevant new knowledge.
Economists use the term economies of scale or
increasing returns to describe the technological
advantages of large-scale production. For
example, if doubling the amount of every input
that the firm uses triples the firm’s output, then
the firm exhibits increasing returns.
Economies of scale may result from
specialization within the firm, which allows
employees to do the task they do best, and
minimizes training time by limiting the skill set
that each worker needs. Economies of scale may
also occur for purely engineering reasons. For
example, transporting more of a liquid requires a
larger pipe, but doubling the capacity of the pipe
increases its diameter (and the material necessary
to construct it) by much less than a factor of two.
For proof, check The size and cost of a pipe in the
Einstein at the end of this section.
But there are also built-in diseconomies of
scale. Think of the firm’s owners, managers, work
supervisors and production workers. Suppose that
each supervisor can direct 10 production workers,
while each manager can direct 10 supervisors. If
the firm employs 10 production workers, then the
owner can do the management and supervision. If
it employs 100 production workers, it needs to
add a layer of 10 supervisors. If it grows to 1,000
production workers, it will need to recruit
another layer of management to supervise the first
layer of supervisors. So increasing production
workers requires more than a proportional
increase in supervision and management. The
only way the firm could increase all inputs proportionally would be to
reduce the intensity of supervision, with associated losses in productivity.
We’ll call this diseconomy of scale the Dilbert law of firm hierarchy, (after a
Dilbert comic strip (https://tinyco.re/8720977)). See the Einstein at the end
of this section for how to calculate the diseconomy of scale that our Dilbert
law implies.
Cost advantages
Cost per unit may fall as the firm produces more output, even if there are
constant or even decreasing returns to scale. This happens if there is a fixed
cost that doesn’t depend on the number of units—it will be the same
whether the firm produces one unit, or many. An example would be the
cost of research and development (R&D) and product design, acquiring a
licence to engage in production, or obtaining a patent for a particular
technique. Marketing expenses, such as advertising, are another fixed cost.
The cost of a 30-second advertisement during the television coverage of the
US Super Bowl football game in 2014 was $4 million, which would only be
justifiable if a large number of units would be sold as a result.
A firm’s attempt to gain favourable treatment by government bodies
through lobbying, contributions to election campaigns, and public relations
UNIT 7 THE FIRM AND ITS CUSTOMERS
272
network economies of scale These
exist when an increase in the
number of users of an output of a
firm implies an increase in the
value of the output to each of
them, because they are connected
to each other.
expenditures are also a kind of fixed cost. These expenses are more or less
independent of the level of the firm’s output.
Secondly, large firms are able to purchase their inputs on more
favourable terms, because they have more bargaining power than small
firms when negotiating with suppliers.
Demand advantages
Large size may benefit a firm in selling its product, not just in producing it.
This occurs when people are more likely to buy a product or service if it
already has a lot of users. For example, a software application is more useful
when everybody is using a compatible version. These demand-side benefits
of scale are called network economies of scale, and there are many
examples in technology-related markets.
Production by a small group of people is therefore often too costly to
compete with larger firms. But while small firms typically either grow or
die, there are limits to growth known as diseconomies of scale, or
decreasing returns.
A larger firm needs more layers of management and supervision. Firms
typically organize themselves as hierarchies in which employees are
supervised by those at a higher level and, as the firm grows, the
organizational costs will grow as a proportion of the firm’s overall costs.
We have already seen in Unit 6 that firms may outsource production of
components. Firm growth is limited, in part, because sometimes it is
cheaper to purchase part of the product than to manufacture it themselves.
Apple would be gigantic if it decided that Apple employees would produce
the touch screens, chipsets, and other components that make up the iPhone
and iPad rather than purchasing these parts from Toshiba, Samsung, and
other suppliers. Apple’s outsourcing strategy limits the firm’s size, and
increases the size of Toshiba, Samsung, and other firms that produce
Apple’s components.
In the next section, we will model the way that a firm’s costs depend on
its scale of production.
QUESTION 7.4 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
If a firm’s technology exhibits constant returns to scale, doubling
the inputs leads to doubling of the output level.
If a firm’s technology exhibits decreasing returns to scale, doubling
the inputs more than doubles the output level.
If a firm’s technology exhibits economies of scale, costs per unit will
fall as the firm expands its production.
If a firm’s technology exhibits diseconomies of scale, doubling the
inputs leads to less than doubling of the output level.
7.2 ECONOMIES OF SCALE
273
EINSTEIN
The size and cost of a pipe
We can use simple mathematics to work out how much the cost of
making a pipe increases when the area of the cross-section doubles. The
formula for the area of a circle is:
Let us assume the area of the pipe was originally 10 cm2, and then it was
doubled in size to 20 cm2. We can use the equation above to find the
radius of the pipe in each case.
When the area of the pipe is 10:
When the area of the pipe is 20:
The cost of the material used to make a pipe of given length is
proportional to its circumference. The formula for the circumference of
a circle is:
When the area of the pipe is 10:
When the area of the pipe is 20:
The pipe has doubled in capacity, but the circumference, and hence the
cost, has only increased by a factor of:
We can clearly see that the firm has benefitted from economies of scale.
Diseconomies of scale: CORE’s Dilbert law of firm hierarchy
If every 10 employees at a lower level must have a supervisor at a higher
level, then a firm that has 10x production workers (the bottom of the
ladder) will have x levels of management, 10x−1 supervisors at the lowest
level, 10x−2 at the second lowest level, and so on.
A firm with 1 million (106) production workers will thus have
100,000 (105 = 106−1) lowest-level supervisors. Dilbert did not invent
the law. He is too closely watched by his supervisor to have time for that.
The CORE team did.
UNIT 7 THE FIRM AND ITS CUSTOMERS
274
opportunity cost When taking an
action implies forgoing the next
best alternative action, this is the
net benefit of the foregone
alternative.
opportunity cost of capital The
amount of income an investor
could have received by investing
the unit of capital elsewhere.
fixed costs Costs of production that
do not vary with the number of
units produced.
marginal cost The effect on total
cost of producing one additional
unit of output. It corresponds to the
slope of the total cost function at
each point.
MARGINAL COST
At each point on the cost function,
the marginal cost (MC) is the addi-
tional 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:
7.3 PRODUCTION: THE COST FUNCTION FOR
BEAUTIFUL CARS
To set the price and the quantity produced for Apple-Cinnamon Cheerios,
the manager needed to know the demand function and the production
costs. Since we assumed that the cost of producing every pound of Cheerios
was the same, the scale of production was determined by the demand for
the good. In this section and the next, we will look at a different example, in
which costs vary with the level of production.
Consider a firm that manufactures cars. Compared with Ford, which
produces around 6.6 million vehicles a year, this firm produces specialty
cars and will turn out to be rather small, so we will call it Beautiful Cars.
Think about the costs of producing and selling cars. The firm needs
premises (a factory) equipped with machines for casting, machining, pressing,
assembling, and welding car body parts. It may rent them from another firm,
or raise financial capital to invest in its own premises and equipment. 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, market, and sell the finished cars.
The firm’s owners—the shareholders—would usually 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 investment, is another example of opportunity cost (discussed in
Unit 3), in this case called the opportunity cost of capital. Part of the cost of
producing cars is the amount that has to be paid out to shareholders to cover
the opportunity cost of capital—that is, to induce them to continue to invest in
the assets that the firm needs to produce cars.
The more cars produced, the higher the total costs will be. The upper
panel of Figure 7.6 shows how total costs might depend on the quantity of
cars, Q, produced per day. This is the firm’s cost function, C(Q). From the
cost function, we have worked out the average cost of a car, and how it
changes with Q; the average cost curve (AC) is plotted in the lower panel.
We can see in Figure 7.6 that Beautiful Cars has decreasing average costs at
low levels of production: the AC curve slopes downward. At higher levels of
production, average cost increases so the AC curve slopes upward. This might
happen because the firm has to increase the number of shifts per day on the
assembly line. Perhaps it has to pay overtime rates, and equipment breaks
down more frequently when the production line is working for longer.
Figure 7.7 shows how to find the marginal cost of a car, that is, the cost
of producing one more car. In Unit 3, we saw that the marginal product for
a given production function was the additional output produced when the
input was increased by one unit, corresponding to the slope of the produc-
tion function. Similarly, Figure 7.7 demonstrates that the marginal cost
(MC) corresponds to the slope of the cost function.
By calculating the marginal cost at every value of Q, we have drawn the
whole of the marginal cost curve in the lower panel of Figure 7.7. Since
marginal cost is the slope of the cost function and the cost curve gets
steeper as Q increases, the graph of marginal cost is an upward-sloping line.
In other words, Beautiful Cars has increasing marginal costs of car produc-
tion. It is the rising marginal cost that eventually causes average costs to
increase.
7.3 PRODUCTION: THE COST FUNCTION FOR BEAUTIFUL CARS
275
350,000
80,000
4,000
3,400
3,600
AC at A
= slope of OA
= C0/ Q0
= 4,000
AC at B
= slope of OB
= 3,400
AC at D
= slope of OD
= 3,600
200
0
Q0
C0=
F
A
B
D
40
Q1
60
Q2
O
A
B
D
Quantity of cars, Q
20 40 60
Av
er
ag
e
co
st
o
f p
ro
du
ct
io
n
($
)
To
ta
l c
os
t o
f p
ro
du
ct
io
n,
C
(Q
) (
$)
Figure 7.6 Beautiful Cars: Cost function and average cost.
1. The cost function
The top panel shows the cost function,
C(Q). It shows the total cost for each
level of output, Q.
2. Fixed costs
Some costs do not vary with the
number of cars. For example, once the
firm has decided the size of its factory
and invested in equipment, those 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.
3. Total costs are increasing
As Q increases, total costs rise and the
firm needs to employ more production
workers. At point A, 20 cars are
produced (we call this Q0) costing
$80,000 (we call this C0).
4. Average cost
If the firm produces 20 cars per day, the
average cost of a car is C0 divided by
Q0, which is shown by the slope of the
line from the origin to A. The average
cost is now $80,000/20 = $4,000. We
have plotted the average cost at point
A on the lower panel.
5. Falling average cost
As output rises above A, fixed costs are
shared between more cars. The
average cost falls. At point B, the total
cost is $136,000, average cost is $3,400.
6. Rising average cost
Average cost is lowest at point B. When
production increases beyond B, the line
to the origin gets gradually steeper
again. At D average cost has risen to
$3,600.
7. The average cost curve
We can calculate the average cost at
every value of Q to draw the average
cost (AC) curve in the lower panel.
UNIT 7 THE FIRM AND ITS CUSTOMERS
276
Notice that in Figure 7.7 we calculated marginal cost by finding the
change in costs, ∆C, from producing one more car. Sometimes it is more
convenient to take a different increase in quantity. If we know that costs
rise by ∆C = $12,000 when 5 extra cars are produced, then we could
350,000
80,000
6,000
2,200
3,400
4,600
F
A
1
D
A
B
D
MC
AC
A
D
1
200
200 40 60
40 60
To
ta
l c
os
t o
f p
ro
du
ct
io
n,
C
(Q
)
Av
er
ag
e
an
d
m
ar
gi
na
l
co
st
s
of
p
ro
du
ct
io
n
Quantity of cars, Q
ΔC = 3,400
ΔC ΔC = 4,600
Q0
C0=
Q1 Q2
ΔC
ΔC = 2,200
Figure 7.7 The marginal cost of a car.
1. Total cost, average cost and marginal
cost
The upper panel shows the cost func-
tion (also called the total cost curve).
The lower panel shows the average
cost curve. We will plot the marginal
costs in the lower panel too.
2. Total cost
Suppose the firm is producing 20 cars
at point A. The total cost is $80,000.
3. Marginal cost
The marginal cost is the cost of
increasing output from 20 to 21. This
would increase total costs by an
amount that we call ∆C, equal to
$2,200. The triangle drawn at A shows
that the marginal cost is equal to the
slope of the cost function at that point.
4. Marginal cost at A
We have plotted the marginal cost at
point A in the lower panel.
5. Marginal cost at D
At point D, where Q = 60, the cost func-
tion is much steeper. The marginal cost
of producing an extra car is higher: ∆C
= $4,600.
6. Marginal cost at B
At point B, the curve is steeper than at
A, but flatter than at D: MC = $3,400.
7. The cost function
Look at the shape of the whole cost
function. When Q = 0 it is quite flat, so
marginal cost is low. As Q increases, the
cost function gets steeper, and mar-
ginal cost gradually rises.
8. The marginal cost curve
If we calculate marginal cost at every
point on the cost function, we can draw
the marginal cost curve.
7.3 PRODUCTION: THE COST FUNCTION FOR BEAUTIFUL CARS
277
calculate ∆C/∆Q, where ∆Q = 5, to get an estimate for MC of $2,400 per
car. In general, when the cost function is curved, a smaller ∆Q gives a more
accurate estimate.
Now look at the shapes of the AC and MC curves, shown again in Figure
7.8. You can see that the AC is downward-sloping at values of Q where the
AC is greater than the MC, and it is upward-sloping where AC is less than
MC. This is not just a coincidence: it happens whatever the shape of the
total cost function. Follow the analysis in Figure 7.8 to see why this
happens.
Leibniz: Average and marginal cost
functions (https://tinyco.re/
L070301)
Quantity of cars, Q
4,000
2,000
200
Q0
40
Q1
60
Q2
A
B D
MC
AC
Av
er
ag
e
an
d
m
ar
gi
na
l
co
st
s
of
p
ro
du
ct
io
n
($
)
Figure 7.8 Average and marginal cost curves.
1. Average and marginal cost
The diagram shows both the average
cost curve and the marginal cost curve.
2. MC < AC when Q = 20
Look at point A on the AC curve. When
Q = 20, the average cost is $4,000, but
the marginal cost is only $2,200. So if 21
cars rather than 20 are produced, that
will reduce the average cost. Average
cost is lower at Q = 21.
3. Average cost curve slopes downward
when AC > MC
At any point, like point A, where AC >
MC, the average cost will fall if one
more car is produced, so the AC curve
slopes downward.
4. Average cost curve slopes upward
when AC < MC
At point D where Q = 60, the average
cost is $3,600, but the cost of producing
the 61st car is $4,600. So the average
cost of a car will rise if 61 cars are
produced. When AC < MC, the average
cost curve slopes upward.
5. When AC = MC
At point B, where the average cost is
lowest, the average and marginal costs
are equal. The two curves cross. When
AC = MC, the AC curve doesn’t slope up
or down: it is flat (the slope is zero).
UNIT 7 THE FIRM AND ITS CUSTOMERS
278
QUESTION 7.5 CHOOSE THE CORRECT ANSWER(S)
Consider a firm with fixed costs of production. Which of the following
statements about its average cost (AC) and marginal cost (MC) is
correct?
When AC = MC, the AC curve has a zero slope.
When AC > MC, the MC curve is downward-sloping.
When AC < MC, the AC curve is downward-sloping.
The MC curve cannot be horizontal.
QUESTION 7.6 CHOOSE THE CORRECT ANSWER(S)
Suppose that the unit cost of producing a pound of cereal is $2,
irrespective of the level of output. (This means there are no fixed costs,
that is, costs that are present for any level of output, including zero.)
Which of the following statements is correct?
The total cost curve is a horizontal straight line.
The average cost curve is downward-sloping.
The marginal cost curve is upward-sloping.
The average cost and the marginal cost curves coincide.
EXERCISE 7.2 THE COST FUNCTION FOR APPLE-CINNAMON CHEERIOS
Of course, cost functions can have different shapes from the one we drew
for Beautiful Cars. For Apple-Cinnamon Cheerios, we assumed the average
cost was constant, so that the unit cost of a pound of cereal was equal to
$2, regardless of the quantity produced.
1. Draw the cost function (also called the total cost curve) for this case.
2. What do the marginal and average cost functions look like?
3. Now suppose that the marginal cost of producing a pound of Cheerios
was $2, whatever the quantity, but there were also some fixed produc-
tion costs. Draw the total, marginal, and average cost curves in this
case.
7.3 PRODUCTION: THE COST FUNCTION FOR BEAUTIFUL CARS
279
economies of scope Cost savings
that occur when two or more
products are produced jointly by a
single firm, rather being produced
in separate firms.
Economists Rajindar and Manjulika Koshal studied the cost functions of
universities in the US. They estimated the marginal and average costs of
educating graduate and undergraduate students in 171 public universities
in the academic year 1990–91. As you will see in Exercise 7.3, they found
decreasing average costs. They also found that the universities benefitted
from what are termed economies of scope: there were cost savings from
producing several products—in this case graduate education,
undergraduate education, and research—together.
If you want to know more about costs, George Stigler, an economist, has
written an entertaining discussion of the subject in chapter 7 of his book.
EXERCISE 7.3 COST FUNCTIONS FOR UNIVERSITY EDUCATION
Below you can see the average and marginal costs per student for the year
1990–91 that Koshal and Koshal calculated from their research.
Students MC ($) AC ($) Total cost ($)
2,750 7,259 7,659 21,062,250
5,500 6,548 7,348 40,414,000
8,250 5,838 7,038
11,000 5,125 6,727 73,997,000
13,750 4,417 6,417 88,233,750
Undergraduates
16,500 3,706 6,106 100,749,000
Students MC ($) AC ($) Total cost ($)
550 6,541 12,140 6,677,000
1,100 6,821 9,454 10,339,400
1,650 7,102 8,672
2,200 7,383 8,365 18,403,000
2,750 7,664 8,249 22,684,750
Graduates
3,300 7,945 8,228 27,152,400
1. How do average costs change as the numbers of students rise?
2. Using the data for average costs, fill in the missing figures in the total
cost column.
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 mar-
ginal and average costs.) Plot them on a single chart using the numbers
in the total cost column.
5. What are the main differences between the universities’ cost structures
for undergraduates and graduates?
6. Can you think of any explanations for the shapes of the graphs you
have drawn?
Rajindar K. Koshal and Manjulika
Koshal. 1999. ‘Economies of Scale
and Scope in Higher Education: A
Case of Comprehensive
Universities’ (https://tinyco.re/
8137580). Economics of Education
Review 18 (2): pp. 269–77.
Economies of Scale and Scope
(https://tinyco.re/7593630). The
Economist. Updated 20 October
2008.
George J. Stigler. 1987. The Theory
of Price. New York, NY: Collier
Macmillan.
UNIT 7 THE FIRM AND ITS CUSTOMERS
280
differentiated product A product
produced by a single firm that has
some unique characteristics
compared to similar products of
other firms.
willingness to pay (WTP) An
indicator of how much a person
values a good, measured by the
maximum amount he or she would
pay to acquire a unit of the good.
See also: willingness to accept.
7.4 DEMAND AND ISOPROFIT CURVES: BEAUTIFUL
CARS
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.
We expect a firm selling a differentiated product to face a downward-
sloping demand curve. We have already seen an empirical example in the
case of Apple-Cinnamon Cheerios (another differentiated product). If the
price of a Beautiful Car is high, demand will be low because the only con-
sumers who will buy it are those who strongly prefer Beautiful Cars to all
other makes. As the price falls, more consumers, who might otherwise have
purchased a Ford or a Volvo, will be attracted to a Beautiful Car.
The 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. For a simple model of the demand for
Beautiful Cars, imagine that there are 100 potential consumers who would
each buy one Beautiful Car today, if the price were low enough.
Each consumer has a willingness to pay (WTP) for a Beautiful Car,
which depends on how much the customer personally values it (given the
resources to buy it, of course). A consumer will buy a car if the price is less
than or equal to his or her WTP. Suppose we line up the consumers in order
of WTP, with the highest first, and plot a graph to show how the WTP
varies along the line (Figure 7.9). 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 $3,200 is 60.
Pr
ic
e,
P
: W
TP
($
)
0
2,000
4,000
6,000
8,000
Quantity, Q: number of consumers per day
0 20 60 80 120100
A
40
3,200
Figure 7.9 The demand for cars (per day).
7.4 DEMAND AND ISOPROFIT CURVES: BEAUTIFUL CARS
281
If P is lower, there are a larger number of con-
sumers willing to buy, so 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 the price rises, the quantity that
consumers demand falls. In other words, 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.
QUESTION 7.7 CHOOSE THE CORRECT ANSWER(S)
The diagram depicts two alternative demand curves, D and D′, for a
product. Based on this graph, which of the following are correct?
Pr
ic
e,
P
(£
)
0
12,000
10,000
8,000
6,000
4,000
2,000
Quantity of consumers, Q
0 30 80 90 100706050402010
D’D
On demand curve D, when the price is £5,000, the firm can sell 15
units of the product.
On demand curve D′, the firm can sell 70 units at a price of £3,000.
At price £1,000, the firm can sell 40 more units of the product on D′
than on D.
With an output of 30 units, the firm can charge £2,000 more on D′
than on D.
Like the producer of Apple-Cinnamon Cheerios, Beautiful Cars will choose
the price, P, and the quantity, Q, taking into account its demand curve and
its production costs. The demand curve determines the feasible set of com-
binations of P and Q. To find the profit-maximizing point, we will draw the
isoprofit curves, and look for the point of tangency as before.
The Law of Demand dates back to the seventeenth century,
and is attributed to Gregory King (1648–1712) and Charles
Davenant (1656–1714). King was a herald at the College of
Arms in London, who produced detailed estimates of the popu-
lation and wealth of England. Davenant, a politician, published
the Davenant-King Law of Demand in 1699, using King’s data. It
described how the price of corn would change depending on
the size of the harvest. For example, he calculated that a
‘defect’, or shortfall, of one-tenth (10%) would raise the price
by 30%.
UNIT 7 THE FIRM AND ITS CUSTOMERS
282
economic profit A firm’s revenue minus its total costs (includ-
ing the opportunity cost of capital).
normal profits Corresponds to zero economic profit and means
that the rate of profit is equal to the opportunity cost of capital.
See also: economic profit, opportunity cost of capital.
profit margin The difference
between the price and the mar-
ginal cost.
The isoprofit curves
The firm’s profit is the difference between its revenue (the price multiplied
by quantity sold) and its total costs, C(Q):
This calculation gives us what is known as the
economic profit. Remember that the cost func-
tion includes the opportunity cost of capital (the
payments that must be made to the owners to
induce them to hold shares), which is referred to
as normal profits. Economic profit is the addi-
tional profit above the minimum return required
by shareholders.
Equivalently, profit is the number of units of output multiplied by the
profit per unit, which is the difference between the price and the average
cost:
From this equation you can see that the shape of the isoprofit curves will
depend on the shape of the average cost curve. Remember that for Beautiful
Cars, the average cost curve slopes downward until Q = 40, and then
upward. Figure 7.10 shows the corresponding isoprofit curves. They look
similar to those for Cheerios in Figure 7.3, but there are some differences
because the average cost function has a different shape. The lowest (lightest
blue) curve shows the zero-economic-profit curve: the combinations of
price and quantity for which economic profit is equal to zero, because the
price is just equal to the average cost at each quantity.
Notice that in Figure 7.10:
• Isoprofit curves slope downward at points where P > MC.
• Isoprofit curves slope upward at points where P < MC.
The difference between the price and the marginal cost is called the profit
margin. At any point on an isoprofit curve the slope is given by:
To understand why, think again about point G in Figure 7.10 at which
Q = 23, and the price is much higher than the marginal cost. If you:
1. increase Q by 1
2. reduce P by (P − MC)/Q
then your profit will stay the same because the extra profit of (P − MC) on
car 24 will be offset by a fall in revenue of (P − MC) on the other 23 cars.
7.4 DEMAND AND ISOPROFIT CURVES: BEAUTIFUL CARS
283
The same reasoning applies at every point where P > MC. The profit
margin is positive so the slope is negative. And it also applies when P < MC.
In this case, the profit margin is negative so an increase in price is required
to keep profit constant when quantity rises by 1. The isoprofit curve slopes
upward.
Leibniz: Isoprofit curves and their
slopes (https://tinyco.re/L070401)
0 10 20 30 40 50 60 70 80 90 100 110 120
Marginal cost
Isoprofit curve: $150,000
B
Isoprofit curve: $70,000
Zero-economic-profit curve (AC curve)
K
H
G
Profit = Q(P − AC)
Quantity of cars, Q
Pr
ic
e,
m
ar
gi
na
l c
os
t (
$)
0
2,000
3,000
1,000
4,000
5,000
6,000
7,000
10,000
9,000
8,000
Figure 7.10 Isoprofit curves for Beautiful Cars.
1. The zero-economic-profit curve
The lightest blue curve is the firm’s
average cost curve. If P = AC, the firm’s
economic profit is zero. So the AC curve
is also the zero-profit curve: it shows all
the combinations of P and Q that give
zero economic profit.
2. The shape of the
zero-economic-profit curve
Beautiful Cars has decreasing AC when
Q < 40, and increasing AC when Q > 40.
When Q is low, it needs a high price to
break even. If Q = 40 it could break
even with a price of $3,400. For Q > 40,
it would need to raise the price again
to avoid a loss.
3. AC and MC
Beautiful Cars has increasing marginal
costs: the upward-sloping line.
Remember that the AC curve slopes
down if AC > MC, and up if AC < MC.
The two curves cross at B, where AC is
lowest.
4. Isoprofit curves
The darker blue curves show the com-
binations of P and Q giving higher
levels of profit, so points G and K give
the same profit.
5. Profit = Q(P − AC)
At G where the firm makes 23 cars, the
price is $6,820 and the average cost is
$3,777. The firm makes a profit of
$3,043 on each car, and its total profit is
$70,000.
6. Higher prices, higher profits
Profit is higher on the curves closer to
the top-right corner in the diagram.
Point H has the same quantity as K, so
the average cost is the same, but the
price is higher at H.
UNIT 7 THE FIRM AND ITS CUSTOMERS
284
QUESTION 7.8 CHOOSE THE CORRECT ANSWER(S)
The diagram depicts the marginal cost curve (MC), the average cost
curve (AC), and the isoprofit curves of a firm. What can we deduce from
the information in the diagram?
Pr
ic
e,
P
0
70
Quantity, Q
10 20
40
20
25
A
B
C
MC
Isoprofit curve
Isoprofit curve
AC
The profit level at A is 500.
The profit level at B is 150.
The price at C is 50.
The price at B is 36.
EXERCISE 7.4 LOOKING AT ISOPROFIT CURVES
The isoprofit curves for Cheerios are downward-sloping, but for Beautiful
Cars they slope downward when Q is low and upward when Q is high.
1. In both cases the higher isoprofit curves get closer to the average cost
curve as quantity increases. Why?
2. What is the reason for the difference in the shape of the isoprofit
curves between the two firms?
7.5 SETTING PRICE AND QUANTITY TO MAXIMIZE
PROFIT
In Figure 7.11 we have shown both the demand curve and the isoprofit
curves for Beautiful Cars. 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 shaded area on the diagram. To maximize profit the firm
should choose the tangency point E, which is on the highest possible iso-
profit curve.
The profit-maximizing price and quantity are P* = $5,440 and Q* = 32,
and the corresponding profit is $63,360. As in the case of Cheerios, the
optimal combination of price and quantity balances the trade-off that the
firm would be willing to make between price and quantity (for a given
profit level), against the trade-off the firm is constrained to make by the
demand curve.
7.5 SETTING PRICE AND QUANTITY TO MAXIMIZE PROFIT
285
The firm maximizes profit at the tangency point, where the slope of the
demand curve is equal to the slope of the isoprofit curve, so that the two
trade-offs are in balance:
• 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 mar-
ginal rate of substitution (MRS) in profit creation, between selling
more and charging more.
At E, the profit-maximizing point, MRT = MRS.
Compared with the multinational giants of the automobile industry,
Beautiful Cars is a small firm: it chooses to make only 32 cars per day. In
terms of its production levels (but not its prices) it is more similar to luxury
brands like Aston-Martin, Rolls Royce and Lamborghini, each of which
produces fewer than 5,000 cars a year. The size of Beautiful Cars is
determined partly by its demand function—there are only 100 potential
buyers per day, at any price. In the longer term, the firm may be able to
increase demand by advertising: bringing its product to the attention of
more consumers, and convincing them of its desirable qualities. But if it
wants to expand production it will also need to look at its cost structure, as
in Figure 7.7 (page 277). At present it has rapidly increasing marginal costs,
so that average cost starts to rise when output per day exceeds 40. With its
current premises and equipment it is difficult to produce more than 40 cars.
Investment in new equipment may help to reduce its marginal cost, and
might make expansion possible.
Leibniz: The profit-maximizing
price (https://tinyco.re/L070501)
Pr
ic
e,
m
ar
gi
na
l c
os
t (
$)
0
10,000
8,000
P*
Q*
Quantity of cars, Q
0 120
Isoprofit curve:
$63,360
Isoprofit curve:
$30,000
Isoprofit curve: $0
Demand curve
Marginal cost
10050
E
Figure 7.11 The profit-maximizing choice of price and quantity for Beautiful Cars.
UNIT 7 THE FIRM AND ITS CUSTOMERS
286
constrained choice problem This
problem is about how we can do
the best for ourselves, given our
preferences and constraints, and
when the things we value are
scarce. See also: constrained
optimization problem.
CONSTRAINED OPTIMIZATION
A decision-maker chooses the
values of one or more variables
• … to achieve an objective
• … subject to a constraint that
determines the feasible set
Constrained optimization
The profit-maximization problem is another constrained choice
problem, like those in earlier units: Alexei’s choice of study time, your own
and Angela’s choices of working hours, and the choice of the wage by
Maria’s employer.
Each of these problems has the same structure:
• The decision-maker wants to choose the values of one or more variables
to achieve a goal, or objective. For Beautiful Cars, the variables are price
and quantity.
• The objective is to optimize something: to maximize utility, minimize
costs, or maximize profit.
• The decision-maker faces a constraint, which limits what is feasible:
Angela’s production function, your budget constraint, Maria’s best
response curve, the demand curve for Beautiful Cars.
In each case, we have represented the decision-maker’s choice graphically,
by showing the indifference curves, which relate to the objective (iso-utility,
isocost, or isoprofit), and the feasible set of outcomes, which is determined
by the constraint. And we have found the solution of the problem at the
tangency point where the MRS (slope of the indifference curve) is equal to
the MRT (slope of the constraint).
Constrained optimization has many applications in economics; such
problems can be solved mathematically, as well as graphically.
QUESTION 7.9 CHOOSE THE CORRECT ANSWER(S)
Figure 7.11 (page 286) depicts the demand curve for Beautiful Cars,
together with the marginal cost and isoprofit curves. The quantity-
price combination at point E is (Q*, P*) = (32, 5,440). The average cost of
producing 50 cars is the same as the average cost of producing 32.
Suppose that the firm keeps the price at P = $5,440 but now produces
50 cars instead of 32. Which of the following is correct?
The firm will now sell all 50 cars at $5,440.
The firm’s profit will increase.
The firm’s profit remains the same.
The firm’s profit is now reduced.
7.5 SETTING PRICE AND QUANTITY TO MAXIMIZE PROFIT
287
marginal revenue The change in
revenue obtained by increasing the
quantity from Q to Q + 1.
QUESTION 7.10 CHOOSE THE CORRECT ANSWER(S)
Figure 7.11 (page 286) depicts the demand curve for Beautiful Cars,
together with the marginal cost and isoprofit curves. At point E, the
quantity-price combination is (Q*, P*) = (32, 5,440) and the profit is
$63,360.
Suppose that the firm chooses instead to produce Q = 32 cars and sets
the price at P = $5,400. Which of the following statements is correct?
The profit remains the same at $63,360.
The profit is reduced to $62,080.
The average cost of production is $3,400.
The firm is unable to sell all the cars.
QUESTION 7.11 CHOOSE THE CORRECT ANSWER(S)
Figure 7.11 (page 286) depicts the demand curve for Beautiful Cars,
together with the marginal cost and isoprofit curves.
Suppose that the firm decides to switch from P* = $5,440 and Q* = 32 to
a higher price, and chooses the profit-maximizing level of output at the
new price. Which of the following statements is correct?
The quantity of cars produced is reduced.
The marginal cost of producing an extra car is higher.
The total cost of production is higher.
The profit is increased due to the new higher price.
7.6 LOOKING AT PROFIT MAXIMIZATION AS MARGINAL
REVENUE AND MARGINAL COST
In the previous section we showed that the profit-maximizing choice for
Beautiful Cars was the point at which the demand curve was tangent to the
highest isoprofit curve. To make maximum profit, it should produce Q = 32
cars and sell them at a price P = $5,440.
We now look at a different method of finding the profit-maximizing
point, without using isoprofit curves. Instead, we use the marginal revenue
curve. Remember that if Q cars are sold at a price P, revenue R is given by R
= P × Q. The marginal revenue, MR, is the increase in revenue obtained by
increasing the quantity from Q to Q + 1.
Figure 7.12a shows you how to calculate the marginal revenue when Q =
20: that is, the increase in revenue if quantity increases by one unit.
Figure 7.12a shows that the firm’s revenue is the area of the rectangle
drawn below the demand curve. When Q is increased from 20 to 21, revenue
changes for two reasons. An extra car is sold at the new price, but since the
new price is lower when Q = 21, there is also a loss of $80 on each of the
other 20 cars. The marginal revenue is the net effect of these two changes.
In Figure 7.12b we find the marginal revenue curve, and use it to find
the point of maximum profit. The upper panel shows the demand curve,
and the middle panel shows the marginal cost curve. The analysis in Figure
7.12b shows how to calculate and plot the marginal revenue curve. When P
is high and Q is low, MR is high: the gain from selling one more car is much
greater than the total loss on the small number of other cars. As we move
UNIT 7 THE FIRM AND ITS CUSTOMERS
288
down the demand curve P falls (so the gain on the last car gets smaller), and
Q rises (so the total loss on the other cars is bigger), so MR falls and
eventually becomes negative.
0 8070605040302010
Loss
Demand curve
G
ain
0
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
Pr
ic
e,
P
($
)
Quantity of cars, Q
Revenue, R = P × Q
Q = 20 P = $6,400 R = $128,000
Q = 21 P = $6,320 R = $132,720
ΔQ = 1 ΔP = $80 MR = ΔR/ΔQ = $4,720
$6,320
−$1,600
Gain in revenue (21st car)
Loss of revenue ($80 on each of the other 20 cars)
Marginal revenue $4,720
Figure 7.12a Calculating marginal revenue.
1. Revenue when Q = 20
When Q = 20, the price is $6,400, and
revenue = $6,400 × 20, the area of the
rectangle.
2. Revenue when Q = 21
If quantity is increased to 21, the price
falls to $6,320. The change in price is
ΔP = −$80. The revenue at Q = 21 is
shown by the area of the new
rectangle, which is $6,320 × 21.
3. Marginal revenue when Q = 20
The marginal revenue at Q = 20 is the
difference between the two areas. The
table shows that the area of the
rectangle is larger when Q = 21. The
marginal revenue is $4,720.
4. Why is MR > 0?
The increase in revenue happens
because the firm gains $6,320 on the
21st car, and this gain is greater than
the loss of 20 × $80 from selling the
other 20 cars at a lower price.
5. Calculating the marginal revenue
The table shows that the marginal
revenue can also be calculated as the
difference between the gain of $6,320
and the loss of $1,600.
7.6 PROFIT MAXIMIZATION AS MARGINAL REVENUE AND MARGINAL COST
289
0 805040302010
Demand curve
60 70
A
B
E
C
D
M
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m
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ev
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)
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A
C
Marginal revenue
Marginal cost
B
D
Pr
ofi
t (
$)
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0
0
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
60,000
40,000
20,000
Pr
ic
e,
P
($
)
Quantity
of cars, Q
Quantity
of cars, Q
Quantity
of cars, Q
–1,000
–20,000
E
Figure 7.12b Marginal revenue, marginal cost, and profit.
1. Demand and marginal cost curves
The upper panel shows the demand
curve, and the middle panel shows the
marginal cost curve. At point A, Q = 10,
P = $7,200, revenue is $72,000.
2. Marginal revenue
The marginal revenue (middle panel) at
A is the difference between the areas
of the two rectangles: MR = $6,320.
3. Marginal revenue when Q = 20
Marginal revenue when Q = 20 and
P = $6,400 is $4,880.
4. Moving down the demand curve
As we move down the demand curve, P
falls and MR falls by more. The gain on
the extra car gets smaller, and the loss
on the other cars is bigger.
5. MR < 0
At point D, the gain on the extra car is
outweighed by the loss on the others,
so the marginal revenue is negative.
6. The marginal revenue curve
Joining the points in the middle panel
gives the marginal revenue curve.
7. MR > MC
MR and MC cross at point E, where
Q = 32. MR > MC at any value of Q
below 32: the revenue from selling an
extra car is greater than the cost of
making it, so it would be better to
increase production.
8. MR < MC
When Q > 32, MR < MC: if the firm was
producing more than 32 cars it would
lose profit if it made an extra car, and it
would increase profit if it made fewer
cars.
UNIT 7 THE FIRM AND ITS CUSTOMERS
290
The marginal revenue curve is usually (although not necessarily) a
downward-sloping line. The lower two panels in Figure 7.12b demonstrate
that the profit-maximizing point is where the MR curve crosses the MC
curve. To understand why, remember that profit is the difference between
revenue and costs, so for any value of Q, the change in profit if Q was
increased by one unit (the marginal profit) would be the difference between
the change in revenue, and the change in costs:
So:
• If MR > MC, the firm could increase profit by raising Q.
• If MR < MC, the marginal profit is negative. It would be better to
decrease Q.
You can see how profit changes with Q in the lowest panel of 7.12b. Just as
marginal cost is the slope of the cost function, marginal profit is the slope of
the profit function. In this case:
• When Q < 32, MR > MC: Marginal profit is positive, so profit increases
with Q.
• When Q > 32, MR < MC: Marginal profit is negative; profit decreases
with Q.
• When Q = 32, MR = MC: Profit reaches a maximum.
Leibniz: Marginal revenue and
marginal cost (https://tinyco.re/
L070601)
9. The firm’s profit
In the lower panel we have plotted the
firm’s profit at each point on the
demand curve. You can see that when
Q < 32, MR > MC, and profit increases if
Q increases. When Q = 32, profit is
maximized. When Q > 32, MR < MC, and
profit falls if Q rises.
7.6 PROFIT MAXIMIZATION AS MARGINAL REVENUE AND MARGINAL COST
291
economic rent A payment or other
benefit received above and beyond
what the individual would have
received in his or her next best
alternative (or reservation option).
See also: reservation option.
gains from exchange The benefits
that each party gains from a
transaction compared to how they
would have fared without the
exchange. Also known as: gains
from trade. See also: economic
rent.
Pareto efficient An allocation with
the property that there is no
alternative technically feasible
allocation in which at least one
person would be better off, and
nobody worse off.
QUESTION 7.12 CHOOSE THE CORRECT ANSWER(S)
This figure shows the marginal cost and marginal revenue curves for
Beautiful Cars. Which of the following statements is correct, based on
the information shown?
M
ar
gi
na
l c
os
t a
nd
m
ar
gi
na
l r
ev
en
ue
($
)
0 805040302010 60 70
A
E
C
Marginal revenue
Marginal cost
B
D
0
–1,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
Quantity
of cars, Q
When Q = 40, the marginal cost is greater than the marginal
revenue so the firm’s profit must be negative.
Revenue is greater when Q = 10 than if Q = 20.
The firm would not choose to produce at point E because marginal
profit is zero.
Profit is greater when Q = 20 than when Q = 10.
7.7 GAINS FROM TRADE
Remember from Unit 5 that when people engage voluntarily in an eco-
nomic interaction, they do so because it makes them better off: they can
obtain a surplus called economic rent. The total surplus for the parties
involved is a measure of the gains from exchange or gains from trade. We
can analyse the outcome of the economic interactions between consumers
and a firm just as we did for Angela and Bruno in Unit 5. We judge the total
surplus, and the way it is shared, in terms of Pareto efficiency and
fairness.
We have assumed that the rules of the game for allocating Cheerios and
cars to consumers are:
1. A firm decides how many items to produce, and sets a price.
2. Then individual consumers decide whether to buy.
These rules reflect typical market institutions for the allocation of con-
sumer goods, although we might imagine alternatives—maybe a group of
people who wanted cars could get together to produce a specification, then
invite manufacturers to tender for the contract.
In the interactions between a firm like Beautiful Cars and its consumers,
there are potential gains for both, as long as the firm is able to manufacture
a car at a cost less than the value of the car to a consumer. Recall that the
demand curve shows the willingness to pay (WTP) of each of the potential
consumers. A consumer whose WTP is greater than the price will buy the
good and receive a surplus, since the value to her of the car is more than she
has to pay for it.
UNIT 7 THE FIRM AND ITS CUSTOMERS
292
total surplus The total gains from
trade received by all parties
involved in the exchange. It is
measured as the sum of the con-
sumer and producer surpluses. See:
joint surplus.
Similarly, the marginal cost curve shows what it costs to make each
additional car (if you start at Q = 0, the marginal cost curve shows how
much it costs to make the first car, then the second, and so on). And if the
marginal cost is lower than the price, the firm receives a surplus too. Figure
7.13 shows how to find the total surplus for the firm and its consumers,
when Beautiful Cars sets the price to maximize its profits.
Pr
ic
e,
m
ar
gi
na
l c
os
t (
$)
0
P* = $5,440
Q* = 3210
Quantity of cars, Q
0 120
Isoprofit curve:
$150,000
Isoprofit curve:
$63,360
Demand curve
Marginal cost
E
20
10,000
Figure 7.13 Gains from trade.
1. Gains from trade
When the firm sets its profit-
maximizing price P* = $5,440 and sells
Q* = 32 cars per day, the 32nd con-
sumer, whose WTP is $5,440, is just
indifferent between buying and not
buying a car, so that particular buyer’s
surplus is equal to zero.
2. A higher WTP
Other buyers were willing to pay more.
The 10th consumer, whose WTP is
$7,200, makes a surplus of $1,760,
shown by the vertical line at the
quantity 10.
3. What would the 15th customer have
been willing to pay?
The 15th consumer has WTP of $6,800
and hence a surplus of $1,360.
4. The consumer surplus
To find the total surplus obtained by
consumers, we add together the
surplus of each buyer. This is shown by
the shaded triangle between the
demand curve and the line where price
is P*. This measure of the consumers’
gains from trade is the consumer
surplus.
5. The producer surplus for the 20th car
Similarly, the firm makes 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 the vertical line in the dia-
gram between P* and the marginal cost
curve.
6. The total producer surplus
To find the total producer surplus, we
add together the surplus on each car
produced: this is the purple-shaded
area.
7. The marginal car
The firm obtains a surplus on the mar-
ginal car: the 32nd and last car is sold
at a price greater than marginal cost.
7.7 GAINS FROM TRADE
293
CONSUMER SURPLUS, PRODUCER SURPLUS, PROFIT
• The consumer surplus is a measure of the benefits of
participation in the market for consumers.
• The producer surplus is closely related to the firm’s profit,
but it is not quite the same thing. Producer surplus is the dif-
ference between the firm’s revenue and the marginal costs
of every unit, but it doesn’t allow for the fixed costs, which
are incurred even when Q = 0.
• The profit is the producer surplus minus fixed costs.
• The total surplus arising from trade in this market, for the
firm and consumers together, is the sum of consumer and
producer surplus.
Pareto efficient An allocation with
the property that there is no
alternative technically feasible
allocation in which at least one
person would be better off, and
nobody worse off.
Pareto improvement A change that
benefits at least one person
without making anyone else worse
off. See also: Pareto dominant.
consumer surplus The consumer’s
willingness to pay for a good minus
the price at which the consumer
bought the good, summed across
all units sold.
producer surplus The price at
which a firm sells a good minus the
minimum price at which it would
have been willing to sell the good,
summed across all units sold.
deadweight loss A loss of total
surplus relative to a Pareto-effi-
cient allocation.
In Figure 7.13, the shaded area above P*
measures the consumer surplus, and the shaded
area below P* is the producer surplus. We see
from the relative size of the two areas in Figure
7.13 that in this market, the firm obtains a greater
surplus share.
As in the voluntary contracts between Angela
and Bruno, both parties gain in the market for
Beautiful Cars, and the division of the gains is
determined by bargaining power. In this case the
firm has more power than its consumers because
it is the only seller of Beautiful Cars. 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 indi-
vidual consumer has no power to bargain for a better deal because the firm
has many other potential customers.
Pareto efficiency
Is the allocation of cars in this market Pareto efficient? The answer is no,
because there are some consumers who do not purchase cars at the firm’s
chosen price, but who would nevertheless be willing to pay more than it
would cost the firm to produce them. In Figure 7.13 we saw that Beautiful
Cars makes a surplus on the marginal car (the 32nd one). The price is
greater than the marginal cost. It could produce another car, and sell it to
the 33rd consumer at a price lower than $5,440 but higher than the produc-
tion cost. This would be a Pareto improvement: both the firm and the
33rd consumer would be better off. In other words, the potential gains
from trade in the market for this type of car have not been exhausted at E.
Suppose the firm had chosen instead point F, where the marginal cost
curve crosses the demand curve. This point represents a Pareto-efficient
allocation, with no further potential Pareto improvements—producing
another car would cost more than any of the remaining consumers would
pay. Figure 7.14 explains why the total surplus, which we can think of as the
pie to be shared between the firm and its customers, would be higher at F.
The total surplus would be higher at the Pareto-efficient point (F) than
at point E. Consumer surplus would be higher, because those who were
willing to buy at the higher price would benefit from the lower price, and
additional consumers would also obtain a surplus. But Beautiful Cars will
not choose F, because producer surplus is lower there (and you can see that
it is on a lower isoprofit curve).
Since the firm chooses E, there is a loss of potential surplus, known as
the deadweight loss. On the diagram it is the triangular area between
Q = 32, the demand curve, and the marginal cost curve.
It might seem confusing that the firm chooses E when we said that at
this point it would be possible for both the consumers and the firm to be
better off. That is true, but only if cars could be sold to other consumers at a
lower price than to the first 32 consumers. The firm chooses E because that
is the best it can do given the rules of the game (setting one price for all
consumers). The allocation that results from price-setting by the producer
of a differentiated product like Beautiful Cars is Pareto inefficient. The firm
uses its bargaining power to set a price that is higher than the marginal cost
UNIT 7 THE FIRM AND ITS CUSTOMERS
294
of a car. It keeps the price high by producing a quantity that is too low,
relative to the Pareto-efficient allocation.
But evaluating whether the outcome is Pareto efficient does not mean
the rules of the game must be kept unchanged. If there is a technically feas-
ible allocation in which at least one person is better off and nobody is worse
off, then E is not Pareto efficient. As a thought experiment, imagine that the
rules of the game were different, and the firm could charge separate prices
to each buyer, just below the buyer’s willingness to pay. Then the firm
would definitely sell to any potential buyer whose willingness to pay
exceeded the marginal cost, and as a result all mutually beneficial trades
would take place. It would produce the Pareto-efficient quantity of cars.
To set individual prices in this way (called perfect price discrimination,
an extreme form of price discrimination), the firm would need to know the
willingness to pay of every buyer. In this hypothetical case the deadweight
loss would disappear. The firm would capture the entire surplus: there
would be producer surplus, but no consumer surplus. We might think this
unfair, but the market allocation would be Pareto efficient.
0
P0
0 120
Isoprofit curve:
$150,000
Isoprofit curve:
$63,360
Demand curve
Marginal cost
E
FDWL
10,000
Pr
ic
e,
m
ar
gi
na
l c
os
t (
$)
P* = $5,440
Q* = 32
Quantity of cars, Q
Q0
Figure 7.14 Deadweight loss.
1. Unexploited gains from trade
The firm’s profit-maximizing price and
quantity is at point E, but there are
unexploited gains from trade. The firm
could make one more car and sell it to
the 33rd consumer for more than it
would cost to produce.
2. A Pareto-efficient allocation
Suppose the firm chooses F instead,
selling Q0 cars at a price P0 equal to
the marginal cost. This allocation is
Pareto efficient: making another car
would cost more than P0, and there are
no more consumers willing to pay that
much.
3. A higher consumer surplus
The consumer surplus is higher at F
than at E.
4. A higher total surplus
The producer surplus is lower at F than
at E, but the total surplus is higher.
5. Deadweight loss
At E, there is a deadweight loss equal
to the area of the white triangle
between Q = 32, the demand curve and
the MC curve.
7.7 GAINS FROM TRADE
295
price elasticity of demand The
percentage change in demand that
would occur in response to a 1%
increase in price. We express this as
a positive number. Demand is
elastic if this is greater than 1, and
inelastic if less than 1.
EXERCISE 7.5 CHANGING THE RULES OF THE GAME
1. Suppose that Beautiful Cars had sufficient informa-
tion and so much bargaining power that it could
charge each consumer, separately, the maximum
they would be willing to pay. Draw the demand and
marginal cost curves (as in Figure 7.14 (page 295)),
and indicate on your diagram:
(a) the number of cars sold
(b) the highest price paid by any consumer
(c) the lowest price paid
(d) the consumer and producer surplus
2. Can you think of any examples of goods that are
sold in this way?
3. Why is this not common practice?
4. Some firms charge different prices to different
groups of consumers—for example, airlines may
charge higher fares for last-minute travellers. Why
would they do this and what effect would it have on
the consumer and producer surpluses?
5. Suppose a competition policy has changed the rules
of the game. How could this give consumers more
bargaining power?
6. Under these rules, how many cars would be sold?
7. Under these rules, what would the producer and
consumer surpluses be?
QUESTION 7.13 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
Consumer surplus is the difference between the consumers’
willingness to pay and what they actually pay.
Producer surplus equals the firm’s profit.
Deadweight loss is the loss incurred by the producer for not selling
more cars.
All possible gains from trade are achieved when the firm chooses its
profit-maximizing output and price.
7.8 THE ELASTICITY OF DEMAND
The firm maximizes profit by choosing the point where the slope of the iso-
profit curve (MRS) is equal to the slope of the demand curve (MRT), which
represents the trade-off that the firm is constrained to make between price
and quantity.
So the firm’s decision 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 calculate the
elasticity, ε, as follows:
ε is the Greek letter epsilon, which is often used to represent elasticity. For a
demand curve, quantity falls when price increases. So the change in demand
is negative if the price change is positive, and vice versa. The minus sign in
the formula for the elasticity ensures that we get a positive number as our
measure of responsiveness. So in this example we get:
UNIT 7 THE FIRM AND ITS CUSTOMERS
296
The price elasticity of demand is related to the slope of the demand curve. 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 steeper demand curve
corresponds to a lower elasticity. But they are not the same thing, and it is
important to notice that the elasticity changes as we move along the
demand curve, even if the slope doesn’t.
Figure 7.15 shows (again) the demand curve for cars, which has a con-
stant slope: it is a straight line. At every point, if the quantity increases by
one (ΔQ = 1), the price falls by $80 (ΔP = –$80):
Since ΔP = −$80 when ΔQ = 1 at every point on the demand curve, it is
easy to calculate the elasticity at any point. At A, for example, Q = 20 and
P = $6,400. So:
And so:
The table in Figure 7.15 calculates the elasticity at several points on the
demand curve. Use the steps in the analysis to see that, as we move down
the demand curve, the same changes in P and Q lead to a higher percentage
change in P and a lower percentage change in Q, so the elasticity falls.
We say that demand is elastic if the elasticity is higher than 1, and
inelastic if it is less than 1. You can see from the table in Figure 7.15 that the
marginal revenue is positive at points where demand is elastic, and negative
where it is inelastic. Why does this happen? When demand is highly elastic,
price will only fall a little if the firm increases its quantity. So by producing
one extra car, the firm will gain revenue on the extra car without losing
much on the other cars and total revenue will rise; in other words, MR > 0.
Conversely, if demand is inelastic, the firm cannot increase Q without a big
drop in P, so MR < 0. In the Einstein at the end of this section, we
demonstrate that this relationship is true for all demand curves.
QUESTION 7.14 CHOOSE THE CORRECT ANSWER(S)
A shop sells 20 hats per week at $10 each. When it
increases the price to $12, the number of hats sold
falls to 15 per week. Which of the following state-
ments are correct?
When the price increases from $10 to $12, demand
increases by 25%.
A 20% increase in the price causes a 25% fall in
demand.
The demand for hats is inelastic.
The elasticity of demand is approximately 1.25.
7.8 THE ELASTICITY OF DEMAND
297
How does the elasticity of demand affect a firm’s decisions? Remember that
the car manufacturer’s profit-maximizing quantity is Q = 32. You can see in
Figure 7.15 that this is on the elastic part of the demand curve. The firm
would never want to choose a point such as D where the demand curve is
inelastic because the marginal revenue is negative there; it would always be
better to decrease the quantity, since that would raise revenue and decrease
costs. So the firm always chooses a point where the elasticity is greater
than 1.
Elasticity < 1
MR < 0
Elasticity > 1
MR > 0
A
B
0
8,000
9,000
6,000
4,000
2,000
7,000
5,000
3,000
1,000
30 40 5020100 12060 70 80 90 100 110
C
Pr
ic
e,
P
: W
TP
($
)
Quantity, Q (number of consumers)
Elasticity = − % Change in Q/% Change in P
A B C
Q 20 40 70
P $6,400 $4,800 $2,400
ΔQ 1 1 1
ΔP −$80 −$80 −$80
% change in Q 5.00 2.50 1.43
% change in P −1.25 −1.67 −3.33
Elasticity 4.00 1.50 0.43
MR $4,720 $1,520 −$3,280
Figure 7.15 The elasticity of demand for cars.
1. This demand curve is a straight line
At each point on the demand curve if Q
increases by 1, P changes by ΔP = −$80.
2. Elasticity at A
At point A, if ΔQ = 1, the % change in Q
is 100 × 1/20 = 5%. Since ΔP = −$80, the
% change in price is 100 × (−80)/6,400 =
−1.25%. The elasticity is 4.00.
3. Elasticity is lower at B than at A
At B, Q is higher, so the percentage
change when ΔP = 1 is lower. Similarly,
P is lower and the percentage change
in P is higher. So the elasticity at B is
lower than at A. The table shows that it
is 1.50.
4. As Q increases, elasticity decreases
The elasticity is below 1 at C.
5. The marginal revenue
The table also shows the marginal
revenue at each point. When the
elasticity is higher than 1, MR > 0. When
the elasticity is below 1, MR < 0.
UNIT 7 THE FIRM AND ITS CUSTOMERS
298
profit margin The difference
between the price and the mar-
ginal cost.
price markup The price minus the
marginal cost divided by the price.
It is inversely proportional to the
elasticity of demand for this good.
Secondly, the firm’s profit margin (the difference between the price and
the marginal cost of production) is closely related to the elasticity of
demand. Figure 7.16 represents a different situation of highly elastic
demand. The demand curve is quite flat, so small changes in price make a
big difference to sales. The profit-maximizing choice is point E. You can see
that the profit margin is relatively small. This means that the quantity of
cars it chooses to make is not far below the Pareto-efficient quantity, at
point F, where the profit margin is zero.
Figure 7.17 shows the decision of a firm with the same costs of car pro-
duction, but less elastic demand for its product. In this case, the profit
margin is high, and the quantity is low. When the price is raised, many con-
sumers are still willing to pay. The firm maximizes 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, shown by the
deadweight loss, are high.
These examples illustrate that the lower the elasticity of demand, the
more the firm will raise the price above the marginal cost to achieve a high
profit margin. When demand elasticity is low, the firm has the power to
raise the price without losing many customers, and the markup, which is
the profit margin as a proportion of the price, will be high. The Einstein at
the end of this section shows you that the markup is inversely proportional
to the elasticity of demand. Leibniz: The elasticity of demand
(https://tinyco.re/L070801)
Pr
ic
e,
m
ar
gi
na
l c
os
t (
$)
0
2,000
4,000
6,000
8,000
Quantity
0 10 20 30 40 50 60 70 80 90 100 110
Marginal cost
Isoprofit curve: $36,360
Demand curve
E
Profit margin F
Figure 7.16 A firm facing highly elastic demand.
7.8 THE ELASTICITY OF DEMAND
299
QUESTION 7.15 CHOOSE THE CORRECT ANSWER(S)
The figure depicts two demand curves, D1 and D2.
Pr
ic
e,
P
($
)
Quantity, Q
A
D1
D2C
B
E
Based on this figure, which of the following statements are correct?
At E, demand curve D1 is less elastic than D2.
The elasticity is the same at A and C.
At E, both demand curves have the same elasticity.
The elasticity is higher at E than at B.
Marginal cost
Isoprofit curve: $87,000
Demand curve
E
F
Pr
ic
e,
m
ar
gi
na
l c
os
t
0
2,000
4,000
6,000
8,000
Quantity
0 10 20 30 40 50 60 70 80 90 100 110
Profit margin
Dead
weight
loss
Figure 7.17 A firm facing less elastic demand.
UNIT 7 THE FIRM AND ITS CUSTOMERS
300
EINSTEIN
The elasticity of demand and the marginal revenue
The diagram shows how to obtain a general formula for the elasticity at
a point (Q, P) on the demand curve.
It also shows how the elasticity is related to the slope of the demand
curve. A flatter demand curve has a lower slope, indicating higher
elasticity.
Pr
ic
e
($
)
Quantity
ΔP
A
P
Q
ΔQ
Figure 7.18 The elasticity of demand and the marginal revenue.
At point A, the price is P and the quantity is Q. If the quantity increases
by ΔQ, the price falls: it changes by ΔP, which is negative.
Suppose that the demand curve is elastic at A. Then the elasticity is
greater than one:
Multiplying by −QΔP (which is positive):
7.8 THE ELASTICITY OF DEMAND
301
and rearranging, we get:
Consider the special case when ΔQ = 1. The inequality becomes:
Now remember that the marginal revenue at point A is the change in
revenue when Q increases by one unit. This change consists of the gain
in revenue on the extra unit, which is P, and the loss on the other units,
which is QΔP. So this inequality tells us that the marginal revenue is
positive.
We have shown that if the demand curve is elastic, MR > 0. Similarly,
if the demand curve is inelastic, MR < 0.
The size of the markup chosen by the firm
We can find a formula that shows that the markup is high when the
elasticity of demand is low.
We know that the firm chooses a point where the slope of the iso-
profit curve is equal to the slope of the demand curve, and that the slope
of the demand curve is related to the price elasticity of demand:
Rearranging this formula:
We also know from Section 7.4:
When the two slopes are equal:
Rearranging this gives us:
The left-hand side is the profit margin as a proportion of the price,
which is called the markup. Therefore:
The firm’s markup is inversely proportional to the elasticity of
demand.
UNIT 7 THE FIRM AND ITS CUSTOMERS
302
•7.9 USING DEMAND ELASTICITIES IN GOVERNMENT
POLICY
Measuring elasticities of demand is useful to policymakers. 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: 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 a government wishing to raise tax revenue should choose to tax
products with inelastic demand.
Several countries, including Mexico and France, have 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. In North America, the figures were 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 dif-
ferent 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. Figure 7.19 shows the prices and elasticities for some of the categories.
You can see that the demand for lower-calorie milk products (category
31) 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.
EXERCISE 7.6 ELASTICITY AND EXPENDITURE
Figure 7.19 (page 304) shows the spending per week in each category of a
US consumer whose total expenditure on food is $80, with typical spend-
ing patterns across food categories. Suppose that the price of category 30,
high-calorie milk products, increased by 10%:
1. By what percentage would his demand for high-calorie milk products
fall?
2. Calculate the quantity he consumes, in grams, before and after the
price change.
3. Calculate his total expenditure on high-calorie milk products before
and after the price change. You should find that expenditure falls.
4. 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.
7.9 USING DEMAND ELASTICITIES IN GOVERNMENT POLICY
303
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%.
EXERCISE 7.7 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. In view of the fact that those who become ill will be cared for at
some public expense, others argue that the government has a role in
keeping people healthy.
In your own words, provide arguments for or against food taxes
designed to encourage healthy eating.
For additional insight, this blog
illustrates one reaction to
Matthew Harding and Michael
Lovenheim’s research: The
Huffington Post. 2014. ‘There’s An
Easy Way To Fight Obesity, But
Conservatives Will HATE It’
(https://tinyco.re/0950519).
Matthew Harding and Michael
Lovenheim. 2013. ‘The Effect of
Prices on Nutrition: Comparing the
Impact of Product- and Nutrient-
Specific Taxes’ (https://tinyco.re/
9374751). SIEPR Discussion Paper
No. 13-023.
Category Type Calories
per serving
Price per
100 g ($)
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
1,540 0.38 2.96 0.845
17 Grain,
pasta,
bread
960 0.53 2.64 0.292
28 Snacks,
candy
433 1.13 4.88 0.270
29 Snacks,
candy
1,727 0.68 7.60 0.295
30 Milk 2,052 0.09 2.32 1.793
31 Milk 874 0.15 1.44 1.972
Figure 7.19 Price elasticities of demand for different types of food. See the Calories
per serving to compare high and low calorie groups of each food type.
Matthew Harding and Michael
Lovenheim. 2013. ‘The Effect of Prices on
Nutrition: Comparing the Impact of
Product- and Nutrient-Specific Taxes’.
SIEPR Discussion Paper No. 13-023.
UNIT 7 THE FIRM AND ITS CUSTOMERS
304
monopoly A firm that is the only
seller of a product without close
substitutes. Also refers to a market
with only one seller. See also:
monopoly power, natural
monopoly.
MARKET FAILURE
Market failure occurs when
markets allocate resources in a
Pareto-inefficient way.
•7.10 PRICE-SETTING, COMPETITION, AND MARKET
POWER
Our analysis of the firm’s pricing decisions applies to any firm producing
and selling a product that is in some way different from that of any other
firm. In the nineteenth 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 monopoly—in
a monopolized market there is only one seller. He showed, as we have done,
that the firm would set a price greater than the marginal production cost.
GREAT 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). Cournot’s 1838 book
Recherches sur les Principes
Mathématiques de la Théorie 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’. Cournot’s work influenced other
nineteenth 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, Cournot’s
analysis of demand and profit maximization is very similar to ours.
We saw in Section 7.6 that when the producer of a differentiated good sets a
price above the marginal cost of production, the market outcome is not
Pareto efficient. When trade in a market results in a Pareto-inefficient
allocation, we describe this as a case of market failure.
The deadweight loss gives us a measure of the consequences of market
failure: the size of the unexploited gains from trade. And we saw in Section
7.7 that the deadweight loss resulting from setting a price above marginal
cost is high when the elasticity of demand is low.
So what determines the elasticity demand for a product, and why do
some firms face more elastic demand than others? To answer this question,
we need to think again about how consumers behave.
Markets with differentiated products reflect differences in the prefer-
ences of consumers. People who want to buy a car are looking for different
combinations of characteristics. A consumer’s 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.
Augustin Cournot and Irving
Fischer. 1971. Researches into the
Mathematical Principles of the
Theory of Wealth. New York, NY:
A. M. Kelley.
7.10 PRICE-SETTING, COMPETITION, AND MARKET POWER
305
monopoly rents A form of eco-
nomic profits, which arise due to
restricted competition in selling a
firm’s product. See also: economic
profit.
substitutes Two goods for which an
increase in the price of one leads to
an increase in the quantity
demanded of the other. See also:
complements.
market power An attribute of a
firm that can sell its product at a
range of feasible prices, so that it
can benefit by acting as a price-
setter (rather than a price-taker).
For example, Figure 7.20 shows the purchase prices of a three-door
1.0 litre hatchback in the UK in January 2014, which a consumer could find
on a price comparison website.
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 can choose between several quite similar cars, the
demand for each of these cars is likely to be quite elastic. 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 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 Fiesta, the more responsive consumers will be to price differ-
ences. 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. Then the firm will have a relatively low price
and profit margin.
In contrast, the manufacturer of a very specialized type of car, quite dif-
ferent 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 monopoly rents (eco-
nomic profits over and above its production costs) arising from its position
as the only supplier of this type of car (likewise, an innovative firm earns
rents while it is the only firm using a new technology: see Unit 2).
So a firm will be in a strong position if there are few firms producing
close substitutes for its own brand, because it faces little competition.
Then its elasticity of demand will be relatively low. We say that such a firm
has market power. It will have sufficient bargaining power in its relation-
ship with customers to set a high price without losing them to competitors.
Competition policy
This discussion helps to explain why policymakers may be concerned about
firms that have few competitors. Market power allows them to set high
prices, and make high profits, at the expense of consumers. Potential con-
sumer surplus is lost both because few consumers buy, and because those
who buy pay a high price. The owners of the firm benefit, but overall there
is a deadweight loss.
A firm selling a niche product catering for the preferences of a small
number of consumers (such as a Beautiful Car or a luxury brand like a
Lamborghini) is unlikely to attract the attention of policymakers, despite
the loss of consumer surplus. But if one firm is becoming dominant in a
large market, governments may intervene to promote competition. In 2000
Price (£)
Ford Fiesta 11,917
Vauxhall Corsa 11,283
Peugeot 208 10,384
Toyota IQ 11,254
Figure 7.20 Car purchase prices in the UK (January 2014, Autotrader.com).
UNIT 7 THE FIRM AND ITS CUSTOMERS
306
cartel A group of firms that collude
in order to increase their joint
profits.
competition policy Government
policy and laws to limit monopoly
power and prevent cartels. Also
known as: antitrust policy.
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. In
Sweden the combined market share of the two firms was 90%. The merged
firm would have been almost a monopoly—the extreme case of a firm that
has no competitors at all.
A particular concern is that when there are only a few firms in a market
they may form a cartel: a group of firms that collude to keep the price high.
By working together and behaving as a monopoly, rather than competing,
they can increase profits. A well-known example is OPEC, an association of
oil-producing countries. OPEC members jointly agree to set production
levels to control the global price of oil. The OPEC cartel played a major role
in sustaining high oil prices at a global level following the sharp increase in
oil prices in 1973 and again in 1979. We return to study the causes of
fluctuations in oil prices in Unit 11 and the effect of the oil price shocks on
inflation and unemployment in Unit 15.
While cartels between private firms are illegal in many countries, firms
often find ways to cooperate in the setting of prices so as to maximize
profits. Policy to limit market power and prevent cartels is known as com-
petition policy, or antitrust policy in the US.
Dominant firms may exploit their position by strategies other than high
prices. 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. 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. Despite its
promise of ‘always low prices’, some people accuse Walmart of using its
power unfairly, to reduce wages in the area around its stores, drive smaller
retailers out of the market, or reduce the profits of its wholesale suppliers
to unsustainable levels. A paper by John Vickers examines the economic
basis for these claims.
EXERCISE 7.8 MULTINATIONALS OR INDEPENDENT RETAILERS?
Imagine that you are a 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 argue in turn that this will only happen if consumers prefer the
supermarket.
Which side are you on?
Richard J. Gilbert and Michael L.
Katz. 2001. ‘An Economist’s Guide
to US v. Microsoft’
(https://tinyco.re/7683758). Journal
of Economic Perspectives 15 (2):
pp. 25–44.
Markus Krajewski. 2014. ‘The Great
Lightbulb Conspiracy’
(https://tinyco.re/3479245). IEEE
Spectrum. Updated 25 September.
Emek Basker. 2007. ‘The Causes
and Consequences of Wal-Mart’s
Growth’ (https://tinyco.re/
6525636). Journal of Economic
Perspectives 21 (3): pp. 177–198.
John Vickers. 1996. ‘Market Power
and Inefficiency: A Contracts
Perspective’. Oxford Review of
Economic Policy 12 (4): pp. 11–26.
7.10 PRICE-SETTING, COMPETITION, AND MARKET POWER
307
QUESTION 7.16 CHOOSE THE CORRECT ANSWER(S)
Suppose that in a small town a multinational retailer is planning to
build a new superstore. Which of the following arguments could be
correct?
The local protestors argue that the close substitutability of some of
the goods sold between the new retailer and existing ones means
that the new retailer faces inelastic demand for those goods, giving
it excessive market power.
The new retailer argues that the close substitutability of some of
the goods implies a high elasticity of demand, leading to healthy
competition and lower prices for consumers.
The local protestors argue that once the local retailers are driven
out, there will be no competition, giving the multinational retailer
more market power and driving up prices.
The new retailer argues that most of the goods sold by local
retailers are sufficiently differentiated from its own goods that their
elasticity of demand will be high enough to protect the local
retailers’ profits.
•7.11 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 com-
petition from other firms. But the firm may be able to move the demand
curve to increase profits by changing 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 high (many consumers would wish to buy it at each price) and the
elasticity low. 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 already many
brands on the market. But technological innovation may provide
opportunities to get ahead of competitors. After Toyota developed the first
mass-produced hybrid car, the Prius, in 1997, there were for some years
very few comparable cars available. Toyota effectively monopolized 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. Ironically, in the 1970s a company called Parker
Brothers spent years fighting in court to protect a monopoly that they had
on a profitable board game called Monopoly. 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
21, we analyse intellectual property rights in more detail.
Advertising is another strategy that 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
John Kay. ‘The Structure of
Strategy’ (reprinted from Business
Strategy Review 1993)
(https://tinyco.re/7663497).
Parker Brothers first marketed a
property-trading board game
under the name Monopoly in 1935.
In a series of court cases in the
1970s, Parker Brothers attempted
to prevent Ralph Anspach, an eco-
nomics professor, from selling a
game called Anti-Monopoly.
Anspach claimed that Parker
Brothers did not have exclusive
rights to sell Monopoly, since the
company had not originally
invented it.
After the court ruled in favour of
Anspach, many competing versions
of Monopoly appeared on the
market.
After a change in the law, Parker
Brothers established the right to
the Monopoly trademark in 1984,
so Monopoly is now a monopoly
again.
UNIT 7 THE FIRM AND ITS CUSTOMERS
308
consumers about the existence and characteristics of its product, attract
them away from its competitors, and create brand loyalty.
According to Schonfeld and Associates, a firm of market analysts,
advertising on breakfast cereals in the US is about 5.5% of total sales
revenue—about 3.5 times higher than the average for manufactured
products. The data in Figure 7.21 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 would see that market share is not closely related to price. But it is clear
from Figure 7.21 that the brands with the highest share are also the ones
that spend the most on advertising. Matthew Shum, an economist, analysed
cereal purchases in Chicago using this dataset, 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 con-
sumers about the product, but rather to increase brand loyalty, and
encourage consumers of other cereals to switch.
7.12 PRICES, COSTS, AND MARKET FAILURE
Market failure occurs when the market allocation of a good is Pareto
inefficient, and we have seen in this unit that one cause of market failure
(we will see others in later units) is firms setting prices above the marginal
cost of producing their goods.
Firms set prices above marginal costs when the goods they produce, like
cars or breakfast cereals, are differentiated from those produced by other
firms, so that they serve consumers with different preferences and face
limited competition (or no competition, in the case of a monopolist produc-
ing a unique good). Firms can benefit from strategies that reduce
competition, but without competition the deadweight loss may be high, so
policymakers try to reduce the loss through competition policy.
Product differentiation is not the only reason for a price above marginal
cost. A second important reason is decreasing average costs, perhaps due to
economies of scale in production, fixed costs, or input prices declining as
Matthew Shum. 2004. ‘Does
Advertising Overcome Brand
Loyalty? Evidence from the
Breakfast-Cereals Market’
(https://tinyco.re/3909324). Journal
of Economics & Management
Strategy 13 (2): pp. 241–72.
Quaker Oats
Raisin Bran
Grape Nuts
Cornflakes
Cheerios
Frosted Flakes
0
1
2
3
4
5
6
0 2 4 6 8
Quarterly national advertising expenditure ($, millions)
M
ar
ke
ts
ha
re
(%
)
Figure 7.21 Advertising expenditure and market share of breakfast cereals in
Chicago (1991–92).
See more https://tinyco.re/9833015
Figure 1 in Matthew Shum. 2004. ‘Does
Advertising Overcome Brand Loyalty?
Evidence from the Breakfast-Cereals
Market’ (https://tinyco.re/3909324).
Journal of Economics & Management
Strategy 13 (2): pp. 241–72.
7.12 PRICES, COSTS, AND MARKET FAILURE
309
natural monopoly A production
process in which the long-run
average cost curve is sufficiently
downward-sloping to make it
impossible to sustain competition
among firms in this market.
the firm purchases larger quantities. In such cases, the average cost of pro-
duction is greater than the marginal cost of each unit, and the average cost
curve slopes downward. The firm’s price must be at least equal to average
cost—otherwise it makes a loss. And that means the price must be above the
marginal cost.
Of course, decreasing average costs mean that firms can produce at
lower cost per unit when operating at a large scale. 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.
Utilities typically have increasing returns to scale. 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, 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. They may choose instead to
regulate the firm’s activities, limiting its discretion over prices in order to
increase consumer surplus. An alternative is public ownership. The
majority of water supply companies 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 privatized and is regulated by a public
sector agency.
A different kind of example is a film production company. The company
spends heavily on hiring actors, camera technicians, a director, purchasing
rights to the script, and advertising the film. These are fixed costs (some-
times called first copy costs). The cost of making available additional copies
of the film (the marginal cost) is typically low: the first copy is cheap to
reproduce. This firm’s marginal costs will be below its average costs
(including the normal rate of profit). If it were to set a price equal to mar-
ginal cost it would go out of business.
The price of a differentiated product is above the marginal cost as a
direct result of the firm’s response to the absence of competing firms and
price-insensitivity of consumers. The source of the problem in the cases of
utilities and films is the cost structure, rather than lack of competition per
se. Electricity is usually not a differentiated product, so buyers of electricity
may be strongly price-sensitive, and the film industry is highly competitive.
But price must be greater than marginal cost for firms to survive.
However, the two problems—limited competition and decreasing
average costs—are often closely related because competition among firms
with downward-sloping average cost curves tends to be winner-takes-all.
The first firm to exploit the cost advantages of large size eliminates other
firms and, as a result, eliminates competition too.
Whatever the underlying reason, a price above marginal cost results in
market failure. Too little is purchased: there are some potential buyers
whose willingness to pay exceeds the marginal cost but falls short of the
market price—so they won’t buy the good and there is a deadweight loss.
UNIT 7 THE FIRM AND ITS CUSTOMERS
310
7.13 CONCLUSION
We have studied how firms producing differentiated goods choose the price
and the quantity of output to maximize their profit. These decisions depend
on the demand curve for the product—especially the elasticity of demand—
and the cost structure for producing it. They will choose a price above the
marginal cost of production—even more so when competition is limited
and the elasticity of demand low.
Increasing returns in production and other cost advantages favour firms
operating at large scale, where the unit cost is low. Innovation can also
reduce costs and raise profits.
When the market price is above the marginal production cost, there is
market failure: the allocation of the good is Pareto inefficient. Firms make
economic profits, but consumer surplus is lower than it would be if the
price was equal to the marginal cost, and there is a deadweight loss. So
policymakers may be concerned when firms achieve a dominant position in
a market. They can use competition policy and regulation to limit the exer-
cise of market power.
Concepts introduced in Unit 7
Before you move on, review these definitions:
• Differentiated product
• Economies of scale
• Cost function
• Willingness to pay
• Demand curve
• Price-setting
• Consumer surplus
• Producer surplus
• Deadweight loss
• Market failure
• Elasticity of demand
• Profit margin
7.14 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Basker, Emek. 2007. ‘The Causes and Consequences of Wal-Mart’s Growth’
(https://tinyco.re/6525636). Journal of Economic Perspectives 21 (3):
pp. 177–198.
Cournot, Augustin, and Irving Fischer. 1971. Researches into the
Mathematical Principles of the Theory of Wealth. New York, NY:
A. M. Kelley.
Gilbert, Richard J., and Michael L. Katz. 2001. ‘An Economist’s Guide to US
v. Microsoft’ (https://tinyco.re/7683758). Journal of Economic
Perspectives 15 (2): pp. 25–44.
Harding, Matthew, and Michael Lovenheim. 2013. ‘The Effect of Prices on
Nutrition: Comparing the Impact of Product- and Nutrient-Specific
Taxes’ (https://tinyco.re/9374751). SIEPR Discussion Paper
No. 13-023.
Kay, John. ‘The Structure of Strategy’ (reprinted from Business Strategy
Review 1993) (https://tinyco.re/7663497).
7.14 REFERENCES
311
Koshal, Rajindar K., and Manjulika Koshal. 1999. ‘Economies of Scale and
Scope in Higher Education: A Case of Comprehensive Universities’
(https://tinyco.re/8137580). Economics of Education Review 18 (2):
pp. 269–277.
Krajewski, Markus. 2014. ‘The Great Lightbulb Conspiracy’
(https://tinyco.re/3479245). IEEE Spectrum. Updated 24 September
2014.
Schumacher, Ernst F. 1973. Small Is Beautiful: Economics as If People Mattered
(https://tinyco.re/3749799). New York, NY: HarperCollins.
Shum, Matthew. 2004. ‘Does Advertising Overcome Brand Loyalty?
Evidence from the Breakfast-Cereals Market’ (https://tinyco.re/
3909324). Journal of Economics & Management Strategy 13 (2):
pp. 241–272.
Statista. 2011. ‘Willingness to pay for a flight in space’ (https://tinyco.re/
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Stigler, George J. 1987. The Theory of Price. New York, NY: Collier
Macmillan.
The Economist. 2008. ‘Economies of Scale and Scope’ (https://tinyco.re/
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Vickers, John. 1996. ‘Market Power and Inefficiency: A Contracts
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UNIT 7 THE FIRM AND ITS CUSTOMERS