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How a firm without close competitors chooses the price and quantity that maximises its
profits, and can increase its profits through product selection and advertising.
What the gains from trade are and how they are distributed between consumers and the
firm.
What the elasticity of demand is, how it affects the firms price and profit margin, and
how an economic policy maker could use this information in the design of tax and
competition policy.
See www.core-econ.org for the full interactive version of The Economy by The CORE Project.
Guide yourself through key concepts with clickable figures, test your understanding with multiple choice
questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements,
watch economists explain their work in Economists in Action and much more.
Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po
7
6
5
4
3
2
Demand curve
80,000
72,000
64,000
56,000
48,000
40,000
32,000
24,000
16,000
8,000
0
0
INTERACT
Follow figures click-by-click in the full interactive version at www.core-econ.org.
If you were the manager at General Mills, how would you choose the price for AppleCinnamon Cheerios in this city, and how many pounds of cereal would you produce?
Suppose that the unit costthe cost of producing each poundof Apple-Cinnamon
Cheerios is $2. Then the calculation you need is:
Profit = (price unit cost) quantity = (P 2) Q
Figure 2 shows the isoprofit curves for different choices of price and quantity. Just as
indifference curves join points in a diagram giving the same level of utility, isoprofit
curves join points that give the same level of profit. You could make $60,000 profit
by selling 60,000 pounds at a price of $3, or 20,000 pounds at $5, or 10,000 pounds
at $8, or in many other ways. The darkest blue curve shows all the possible ways of
making $60,000 profit. The lightest blue line shows the choices of price and quantity
where profit is zero: if you set a price of $2, you would be selling each pound of cereal
for exactly what it cost you to produce, making no profit whatever the amount you
sold. So the zero-profit line is horizontal, joining all the points where P = 2.
10
9
8
7
6
5
4
3
2
80,000
72,000
64,000
56,000
48,000
40,000
32,000
24,000
16,000
8,000
3
2
1
72,000
64,000
56,000
48,000
40,000
32,000
24,000
16,000
Demand curve
8,000
80,000
Figure 3. The profit-maximising choice of price and quantity for Apple-Cinnamon Cheerios.
Source: Isoprofit data is illustrative only, and does not reflect the real-world profitability of the product.
Demand curve data from Hausman, as above.
for any product that consumers might wish to buy, the product demand curve is
a relationship that tells you the number of items (the quantity) they will buy at each
possible price. Lets think about a market for a particular model of car. To keep things
simple, imagine that there are 100 potential consumers who would each buy one car
of this type, today, if the price were low enough.
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
10
20
30
40
50
60
70
80
90
100
110
120
a car manufacturer deciding how many cars to produce, and what price to set,
must take into account the costs of production.
There are many costs of producing and selling cars. The firm needs premisesa
factoryequipped with machines for casting, forging, assembling and welding car
bodies. It may rent them, from another firm perhaps, or raise financial capital in
order to invest in premises and equipment for itself. Then it must purchase the raw
materials and components, and pay production workers to operate the equipment.
Other workers will be needed to manage the production process and market and sell
the finished cars.
The firms ownersthe shareholderswould not be willing to invest in the firm
if they could make better use of their money by investing and earning profits
elsewhere. What they could receive if they invested elsewhere, per dollar of their
investment, is termed the opportunity cost of capital. One component of the cost of
producing cars is the amount that has to be paid out to shareholders to cover the
opportunity cost of capitalthat is, to induce them to continue to invest in the assets
the firm needs to produce cars.
The more cars the firm produces, the higher its total costs will be. The upper panel
of Figure 5 shows how total costs might depend on the quantity of cars, Q, produced.
This is the firms cost function, C(Q).
350,000
B
AC at B
= slope of line OB
= 3,600
C 0= 88,000
0
6,000
Average cost of
production
40
4,400
3,960
3,600
20
AC at D
= slope of line OD
= 3,960
64
D
B
20
40
64
Q0
Q1
Q2
Quantity of cars, Q
350,000
C= 2,000
A
1
C= 5,520
C 0= 88,000
F
0
20
40
64
6,000
MC
5,520
AC
3,600
A
2,000
D
C= 3,600
20
40
64
Q0
Q1
Q2
Quantity of cars, Q
LEIBNIZ
For mathematical derivations of key concepts, download the Leibniz boxes from
www.core-econ.org.
The economists Rajindar and Manjulika Koshal studied the cost functions of public
universities in the US. They estimated the marginal and average costs of educating
graduate and undergraduate students in 171 public universities in the academic year
1990-1, and found increasing returns to scale. They also found that the universities
benefitted from economics of scope: that is, there were cost savings from producing
several productsgraduate education, undergraduate education, and research
together.
10
Undergraduates
Graduates
STUDENTS
MC ($)
AC ($)
2,750
7,259
7,659
TOTAL
COST ($)
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
16,500
3,706
6,106
STUDENTS
MC ($)
AC ($)
550
6,541
12,140
100,749,000
TOTAL
COST ($)
6,677,000
1,100
6,821
9,454
10,399,400
1,650
7,102
8,672
2,200
7,383
8,365
18,403,000
2,750
7,664
8,249
22,648,750
3,300
7,945
8,228
27,152,400
1. Explain how you can tell from the data that returns to scale are increasing for both
graduates and undergraduates.
2. Using the data for average costs, find the missing figures in the total cost columns.
3. Plot the marginal and average cost curves for undergraduate education on
a graph with costs on the vertical axis, and the number of students on the
horizontal axis. On a separate diagram plot the equivalent graphs for graduates.
4. What are the shapes of the total cost functions for undergraduates and graduates?
You could sketch them using what you know about MC and AC; alternatively you
could plot them more accurately using the numbers in the Total Cost columns.
(Hint: they are not straight lines.)
5. What are the main differences between the universities cost structures for
undergraduates and graduates? Can you think of any explanations for the shapes
of the graphs you have drawn?
not all cars are the same. Cars are differentiated products. Each make and model
is produced by just one firm, and has some unique characteristics of design and
performance that differentiate it from the cars made by other firms.
Like the producer of Apple-Cinnamon Cheerios, the car manufacturer chooses the
price, P, and the quantity of cars to produce, Q, taking into account its production
costs, and what it knows about demand for its own particular type of car. The firms
profit is the difference between its revenue (the price multiplied by quantity sold)
and its total costs, C(Q):
Profit = price quantity total costs = PQ C(Q)
Equivalently, it is the number of units of output multiplied by the profit per unit,
which is the difference between the price and the average cost:
Profit = Q(P C(Q)/Q)
This calculation gives us what is known as the economic profit. Remember that the
cost function includes the opportunity cost of capitalthe payments that must be
made to the owners to induce them to hold shares, which are referred to as normal
profits. Economic profit is the additional profit above the minimum return required
by shareholders.
Figure 7 shows the isoprofit curves for the car manufacturer whose cost function
is shown in Figure 6. The curves look similar to those for Cheerios in Figure 2,
but there are some differences because the car manufacturers cost function has a
different shape. The lightest blue curve shows the zero-economic-profit curve: the
combinations of price and quantity for which economic profit is equal to zero
because the price is just equal to the average cost at each quantity.
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12
10,000
Marginal cost
9,000
8,000
H
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
10
20
30
40
50
60
70
80
Quantity of cars, Q
EINSTEIN 1
Calculate the slope of the isoprofit curve. Suppose that a firm is currently selling Q
cars at a price P, with a marginal cost of MC, and that P is greater than MC. If the firm
increased its quantity by 1, but kept the price the same, profit would increase by (PMC). The increase in profit would be (P-MC)/Q per car. So to keep profit constant, the
price of each car would need to decrease by this amount.
This means that the isoprofit curve slopes downward. The slope of the curve is the
amount by which the price has to fall to keep profit constant when Q rises by 1::
Slope = Fall in price,
P = (P-MC)/Q
The same calculation works when MC is greater that P, except that in this case an
increase in price is required to keep profit constant when quantity rises by 1. The
isoprofit curve slopes upward with slope equal to (MC-P)/Q.
In Figure 8 we have added the demand curve for this type of car. What is the best
choice of price and quantity for the manufacturer? The only feasible choices are the
points on or below the demand curve, shown by the red-shaded area on the diagram.
To maximize profit the firm should choose the tangency point E, where it reaches the
highest possible isoprofit curve.
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14
Marginal cost
8,000
Isoprofit curve: $160,000
P*
0
0
Demand curve
Q*
100
120
Quantity of cars, Q
Figure 8. The profit-maximising choice of price and quantity for the car manufacturer.
The profit-maximising price and quantity are P* = $5,440 and Q* = 32, and the
corresponding profit is $56,000. LEIBNIZ 13 shows how to find an equation for the
firms profit-maximising price using calculus, and demonstrates that the equation
can be interpreted in different ways.
when the firm sets its profit-maximising price P* = $5,440 and sells Q* = 32 cars
per day, the 32nd consumer, whose willingness to pay is $5,440, is just indifferent
between buying and not buying a car, so that buyers gain from trade or surplus is
equal to zero. But other buyers were willing to pay more. You can see from Figure 9
that the 10th consumer, whose WTP is $7,200, makes a surplus of $1,760, shown by
the vertical red line in the diagram. The 15th consumer has WTP $6,800 and hence
a surplus of $1,360. To find the total surplus obtained by consumers, we can add
together the surplus of each buyer: this is shown on the diagram by the red-shaded
trianglethe area between the demand curve and the line where price is P*. This
measure of the consumers gains from trade is known as the consumer surplus.
10,000
Marginal cost
8,000
Isoprofit curve: $160,000
Isoprofit curve: $56,000
5,440
P*
Demand curve
0
10
20
32
Q*
Q0
100
120
Quantity of cars, Q
15
16
the firm maximises profit by choosing the point where the slope of the demand
curve is equal to the slope of the isoprofit curve. We can think of its decision in the
same way as we did for the student in Unit 3, who faced a trade-off between exam
marks and hours of free time. Here, the demand curve presents the firm with a tradeoff between price and quantity: the slope shows how much the price will have to be
lowered to sell another car. The slope of the isoprofit curve represents the trade-off
the firm is willing to make: how much the price can be lowered if another car is sold,
without reducing profit. Profit is maximised at the point where the two trade-offs are
in balance.
So a firms choice of price and quantity depends on how steep the demand curve
is: in other words, how much consumers demand for a good will change if the
price changes. The price elasticity of demand is a measure of the responsiveness of
consumers to a price change: it is defined as the percentage change in demand that
would occur in response to a 1% increase in price. For example, suppose that when
the price of a product increases by 10%, we observe a 5% fall in the quantity sold.
Then we can calculate the elasticity as follows:
Elasticity = % change in demand/% change in price = 5/10 = 0.5
The price elasticity of demand is not the same as the slope of the demand curve,
but they are closely related. If the demand curve is quite flat, the quantity changes
a lot in response to a change in price, so the elasticity is high. Conversely, a steep
demand curve corresponds to a low elasticity. In EINSTEIN 2 we show you the precise
relationship between elasticity and the slope of the demand curve.
Figures 10 and 11 show how the elasticity of demand affects the car manufacturers
pricing decisions. Figure 10 represents a situation of highly elastic demand. The
demand curve is flat, so small changes in price make a big difference to sales.
The profit maximising choice is point E. You can see that the profit marginthe
difference between the price and the marginal cost at this pointis relatively small.
This means that the quantity of cars it chooses to make is not far below the quantity
that would maximise total gains from trade, at point F.
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18
EINSTEIN 2
Calculate the elasticity of demand. Suppose that, when the price of a product
increases by 5%, we observe a 10% fall in the quantity sold. Then the elasticity of
demand is 2 (10 divided by 5).
A flatter demand curve has a lower slope, so a higher elasticity.
The diagram below shows how the elasticity of demand can be calculated from the
slope of the demand curve:
At point A, the price is P
and the quantity is Q.
If the price increases by P,
the quantity falls by Q.
Price
Elasticity at A =
% change in Q
% change in P
Q / Q
P / P
P Q
=
Q P
P
1
=
Q slope
=
P
P
A
Q
Quantity
Figure 11 shows the decision of a firm with the same costs of car production, but
inelastic demand for its product. In this case the profit margin is high, and the
quantity is low. When the price is raised, many consumers are still willing to pay.
The firm maximises profits by exploiting this situation, obtaining a higher share of
the surplus, but the result is that fewer cars are sold and the unexploited gains from
trade are high.
Marginal cost
10,000
9,000
8,000
7,000
Isoprofit curve: $42,000
6,000
5,000
4,000
Profit margin
3,000
2,000
Demand curve
1,000
0
10
20
30
40
50
60
70
80
Quantity
Marginal cost
10,000
9,000
8,000
7,000
6,000
Profit
margin
5,000
4,000
3,000
2,000
1,000
0
Demand curve
0
10
20
30
40
50
60
70
80
Quantity
19
20
EINSTEIN 3
We can find a formula for the size of the price markup chosen by the firm, which
shows that the markup is high when the elasticity of demand is low:
From Figure 8 we can see that at the point chosen by the firm, the slope of the
isoprofit curve is equal to the slope of the demand curve. We know that the slope of
the demand curve is related to the price elasticity of demand: elasticity = P/Q x 1/
slope.
Rearranging this formula: slope of demand curve = P/Q x 1/elasticity
We have also calculated: slope of isoprofit curve = (P-MC)/Q
When the two slopes are equal: (P-MC)/Q = P/Q x 1/elasticity
Rearranging this gives us: (P-MC)/P = 1/elasticity
(P-MC)/P is the difference between price and marginal cost as a proportion of the
price, which is a measure of the markup. So we have shown that the firms markup is
inversely proportional to the elasticity of demand.
21
PRICE PER
100G ($)
TYPICAL
SPENDING
PER WEEK
($)
PRICE
ELASTICITY
OF DEMAND
CATEGORY
TYPE
CALORIES
PER SERVING
Fruit and
vegetables
660
0.38
2.00
1.128
Fruit and
vegetables
140
0.36
3.44
0.830
15
Grain, Pasta,
Bread
1540
0.38
2.96
0.854
17
Grain, Pasta,
Bread
960
0.53
2.64
0.292
28
Snacks,
Candy
433
1.13
4.88
0.270
29
Snacks,
Candy
1727
0.68
7.60
0.295
30
Milk
2052
0.09
2.32
1.793
31
Milk
874
0.15
1.44
1.972
22
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% .
our analysis of the firms pricing decisions might be applied to any firm
producing and selling a product that is in some way different from that of any other
firm. In the 19th century the French economist Augustin Cournot carried out a
similar analysis using the example of bottled water from a mineral spring which
has just been found to possess salutary properties possessed by no other. Cournot
referred to this as a case of monopolya market in which there is only one seller. He
showed, as we have done, that the firm would set a price greater than the marginal
production cost.
PAST ECONOMISTS
AUGUSTIN COURNOT
Augustin Cournot (1801-1877) was a French economist, now most famous for
his model of oligopoly (a market with a small number of firms). Cournots 1838
book Recherches sur les Principes Mathmatiques de la Thorie des Richesses
(Research on the Mathematical Principles of the Theory of Wealth) introduced a
new mathematical approach to economics, although he feared it would draw
on me the condemnation of theorists of repute. Cournots work influenced
other 19th century economists such as Marshall and Walras, and established
the basic principles we still use to think about the behaviour of firms. Although
he used algebra rather than diagrams, Cournots analysis of demand and profit
maximisation is very similar to ours.
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24
PRICE
FORD FIESTA
11,917
VAUXHALL CORSA
11,283
PEUGEOT 208
10,384
TOYOTA IQ
11,254
Although the four cars are similar in their main characteristics, the website compares
them on 75 other features, many of which differ between them.
When consumers are able to choose between several quite similar cars, the demand
curve for each of these cars is likely to be quite flat. If the price of the Ford Fiesta,
for example, were to rise, demand would fall because people would choose to buy
one of the other brands instead. Conversely if the price of the Ford Fiesta were to
fall, demand would increase because consumers would be attracted away from the
other cars. The more similar the other cars are to a Ford Fiesta, the more responsive
the analysis in the previous section helps to explain why policymakers may be
concerned about cases of monopoly: a monopolist is able to set high prices, and make
high profits, at the expense of consumers. Potential consumer surplus is lost because
few consumers buy, and because those who do buy pay a high price.
The way in which the policymaker should respond to this situation will depend on
the reason for the existence of a monopoly. If one firm is becoming dominant in a
market, governments may intervene to promote competition. In 2000 the European
Commission prevented the proposed merger of Volvo and Scania on the grounds
that the merged firm would have a dominant position in the heavy trucks market in
Ireland and the Nordic countries, particularly in Sweden where the combined market
share of the two firms was 91%.
A particular cause for concern is that when there are only a few firms in the market
they may form a cartel: a group of firms that collude to keep the price high, rather
than competing with each other. By working together they can increase profits
by behaving as a monopoly. A well-known example is OPEC, an association of oilproducing countries who jointly agree to limit production to maintain a high oil
price. The actions of the OPEC cartel played a major role in sustaining high oil prices
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26
Competition policy is not a solution in all cases. In domestic utilities such as water,
electricity and gas, there are high fixed costs of providing the supply network,
irrespective of the quantity demanded by consumers. The average cost of producing
a unit of water, electricity or gas will be very high unless the firm operates at a large
scale. If a single firm can supply the whole market at lower average cost than two
firms, the industry is said to be a natural monopoly.
In the case of a natural monopoly, a policymaker may choose to regulate the firms
activities, aiming to increase consumer surplus by limiting the firms discretion over
prices. An alternative is public ownership. The majority of water supply companies
the profits that a firm can achieve depend on the demand curve for its product,
which in turn depends on the preferences of consumers and the competition from
other firms. But the firm may be able to move the demand curve to increase profits by
its selection of products, or through advertising.
When deciding what goods to produce, the firm would ideally like to find a product
that is both attractive to consumers and has different characteristics from the
products sold by other firms. In this case demand would be highmany consumers
would wish to buy it at each priceand inelastic. Of course, this is not likely to be
easy: a firm wishing to make a new breakfast cereal, or type of car, knows that there
are many brands on the market already. But technological innovation may provide
opportunities to get ahead of competitors. For some years after Toyota developed the
first mass-produced hybrid car, the Prius, in 1997, there were very few comparable
cars available. Toyota effectively monopolised the hybrid market. By 2013 there were
several competing brands, but the Prius remained the market leader, with more than
50% of hybrid sales.
If a firm has invented or created a new product, it may be able to prevent competition
altogether by claiming exclusive rights to produce it, using patent or copyright laws.
This kind of legal protection of monopoly may help to provide incentives for research
and development of new products, but at the same time limits the gains from trade.
In Unit 20 we analyse intellectual property rights in more detail.
Advertising is another strategy firms can use to influence demand: it is widely
used by both car manufacturers and breakfast cereal producers. When products are
differentiated, the firm can use advertising to inform consumers about the existence
and the characteristics of its product, to attract them away from its competitors, and
to create brand loyalty.
According to the analyst Schonfeld and Associates, advertising on breakfast cereals
in the US is about 5.5% of total sales revenueabout three and a half times higher
than the average for manufactured products. The data in Figure 14 is for the highestselling 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
27
Corn Flakes
Market share %
28
Cheerios
Frosted Flakes
3
Grape Nuts
Quaker Oats
Raisin Bran
1
0
Figure 14. Advertising expenditure and market share of breakfast cereals, Chicago, 1991-92.
Source: Shum, M. 2004. Does Advertising Overcome Brand Loyalty? Evidence from the Breakfast Cereals Market.
Journal of Economics and Management Strategy, 13(2), pp. 241-272, Fig 1.
7.10 CONCLUSION
we have studied how firms producing differentiated products choose the price,
and the quantity of output to produce, to maximise their profit. These decisions
depend on the demand curve for the productespecially the elasticity of demand
and the cost structure for producing it.
But as Figure 15 shows, firms make other decisions that influence the demand curve
and the cost structure. The firm chooses the characteristics of its product through
product innovation, aiming to attract consumers and differentiate itself further from
its competitors, thereby reducing the elasticity of demand. And as we saw in Unit 2,
29
30
1. The product demand curve tells you how many units consumers will buy at each
price.
2. The firms marginal cost is the addition to total cost of making one extra unit of
output.
3. In markets where products are differentiated
Each firm chooses its price and quantity from the feasible set given the demand
for its own brand; the profit-maximising point is where the demand curve touches
the highest isoprofit curve.
The firm sets a price greater than its marginal cost, which means that all the
potential gains from trade are not realised.
The lower is the elasticity of demand (steeper demand curve), the higher is the
firms price relative to its marginal cost, and the higher is its profit margin.
US v. Microsoft
Richard Gilbert and Michael Katz explain the source and strength of Microsofts
power: LINK.
Gilbert, R. J. and Katz, M. L. 2001. An economists guide to US v. Microsoft. Journal of
Economic Perspectives, pp. 25-44.
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32
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