[3.

6] APPLICATIONS TO ECONOMICS 63
optimal output level if not zero satisfies
^(jt*) = t c = 0,

or t c
This principle, that marginal revenue equals marginal cost at the optimal output, is one of the cornerstones
of economic theory. It is a rather intuitive guideline. A firm should continue producing output until the cost
of producing one more unit c is just offset by the revenue that the additional unit will bring in t If
the firm will receive more for the next unit than that unit will add to its cost t c then producing
that next unit will increase the firm's profit and it should carry out the production. If the cost of making one
more unit is more than the revenue that the unit will bring in the market c t then producing that
additional unit will cut into the firm's profit; the firm should have stopped production earlier.
Let's look more carefully at the perfectly competitive case where the revenue function is t ,
In Figure 3.19, we have drawn a typical average cost +c and marginal cost c curve, as in Figure 3.18.
We have added a horizontal line at , , to represent a firm's marginal revenue t and average revenue
curve +t according to (5). The optimal output point where t c is darkened in Figure
3.19 at the intersection of the t and MC-curves.
If the market price , of the output were to increase, the t/ , , in Figure 3.19 would move up
and the corresponding optimal output would increase too. At each stage, price , and optimal output are
related by the equation , c and the optimal output is represented by a point on the marginal cost


:c; APPLICATIONS TO ECONOMICS 64
curve. Another way of stating the fact that, for every price, the optimal amount of output a firm
will supply lies at the point where the horizontal price line crosses the MC-curve is to say that
the MC-curve gives the locus of the price-optimal output combinations. In the language of
economics, the MC-curve is the firm's supply curve, the curve which relates the market price
to the amount produced,
Finally, we bring into the picture the second derivative condition that an interior optimal
output must satisfy. Since O '(JC) = , c
t c
At the interior maximizer, II 0 by Theorem 3.4. This implies that c 0 and leads
to the principle that at its optimal output the firm should be experiencing ., -,/

Demand Functions and Elasticity
A firm's revenue function t can be written as the product of the amount sold times the unit
selling price. In simple models, we assume that the amount sold equals the amount produced.
In the model of perfect competition analyzed in Figure 3.19, we assumed that the selling price is
a scalar , that is independent of the amount produced. However, in models of monopoly (an
industry with a single firm) and oligopoly (an industry dominated by a small number of firms),
there is usually a relationship between the amount of the product in the market and the price at
which the product sells. If this relationship is represented by a function t;, which
expresses the amount consumed in terms of price level , then t is called a demand
function. If the relationship is expressed by a function , c which expresses the price , in
terms of the amount being consumed, then c is called an inverse demand function. In a
single-firm industry, it is the inverse demand function that is the natural factor of the revenue
function, since the latter can be written as
R(x) = p x = G(x) x.
Since c t the inverse demand function is also the firm's average revenue function.
Economists, of course, are deeply interested in how changes in price affect changes in
demand. The natural measure of this sensitivity is the slope of the demand function, t, or
++, As we well know, this -,/ ..-. describes the effect of a unit increase in price
on the purchasing behavior of consumers. However, this sensitivity indicator has one major
disadvantage: it is highly dependent on the units used to measure quantity and price. Suppose,
for example, that a 10-cent increase in price will lead to a million-gallon decrease in the
consumption of gasoline. The marginal demand is
Ax
=
-1*
=
_
1Q5
+, 10





:c; APPLICATIONS TO ECONOMICS 64
65
/ .. -... x ,// . p . u.... / .. -... x ,//
. p dol l ar s , /. /. -,/ ..-. /,. , / / :
t//, / .. .. -// ,// . . / ,/. .-, . /.
. . . / ,. /. /. -,/ ..-. /.-.
+ :
Ap = TO = -
AL
'
: -// -. -//. / /. -... c t- ../. //.
-... / /. .., / ..-. ,. /,. .// /. -,./..
/, /. / . . .// /. ... -,. .-, // .//..
.. ./ .//.. ... . .//.. -... / ..,/ ./.-.
:/. /. / ,//.- .. /. ,.. . / /,. .. / /. ./
/,. t , ., /. percent rate of change /. ./ /,. ..... /,
/. / -.

_ Aq
qo qo'
s. /. .-. . ..- . -.... /. -. . /. .
./ . / .. ,. t .-,/. / /. ,. /,. /- s::
s: /. ,.. . / /,. / ,.
: :: : :
:: 5 : ,..
t .// /. : ,.. ././. .. /. .// . t./ /
.../. . . / ..,
: /.., /. .., -... -,/../, /.. / . .. .// -... // /.
/,. ., . /. /,. ,. ,..,. .- o. -... /
.., . /.-. /. per cent /,. ., ..-... ..... /, /.
per cent /,. ,.


XI p
/. .. /. ,.. /,. ..-. / ./ : ,.. . ,.
:/ .., -... //.. /. price elasticity of demand . ..//,
.,.... /, /. c../ /.. .,/ e. t... /. ..//. .. : ,/.
..
r/
^LP=^1. P-=^1. P=I " s p x \ p \ p
x l S. pl - '
:c; APPLICATIONS TO ECONOMICS 4
The factor AX/AP in the last two terms is just the marginal demand, while the quotient X/P in
the last term is simply the average demand. So, the elasticity can be thought of as the marginal
demand divided by the average demand.
The marginal demand can, of course, be well approximated by the slope F'(P) of the demand
function X F(P). Substituting F'(P) for AX/AP and F(P) for X in (8) yields the calculus form of the
price elasticity:

Notation The discrete version (8) of the price elasticity is called the arc elasticity and is usually
used to compute E when we know only a finite number of price-quantity combinations. The
differentiable version (9) of the price elasticity is called the point elasticity and is used when a
continuous demand curve has been estimated or in proving theorems about price elasticity.
We will soon use (9) to prove an illuminating relationship between elasticity and total
revenue or expenditure. First, we take a closer look at the elasticity and, in the process,
introduce some more vocabulary. A basic assumption about demand functions is that raising the
price of a commodity usually lowers the amount consumed. Mathematically speaking, demand
is a decreasing function of price. (We are ignoring the empirically rare phenomenon of a Giffen
good a good for which lower prices lead to lower consumption.) This assumption means that
AX/AP in (8) and F'(P) in (9) are negative numbers, as we saw in (6), and therefore that the price
elasticity of a good is a negative number. (Some intermediate economics texts define the price
elasticity as the absolute value of the expression in (8) or (9) to avoid dealing with negative
numbers. We won't.)
A good which is rather insensitive to price changes will have a price elasticity close to zero.
Necessities, like fuel oil and medical care, are good examples of this phenomenon. On the other
hand, a good for which small price increases lead to large drops in consumption speaking in
terms of percentages will have a price elasticity that is a large negative number. Luxury
items, like Lamborghinis and ermine coats, and items with many close substitutes, like Froot
Loops or Cap'n Crunch cereals, are examples of this phenomenon. The following definitions
add some precision to these concepts.
Definition A good whose price elasticity lies between 0 and 1 is called inelastic. A good
whose price elasticity lies between -1 and is called elastic. A good whose price elasticity
equals 1 is said to be unit elastic.
If the price of a good goes up, the change in total expenditure on that good is, at first glance,
indeterminate, since expenditure is price times quantity, and the two move in opposite
directions. As the next theorem shows, the elasticity of the good in question resolves this
ambiguity.
Theorem 3.8 For an inelastic good, an increase in price leads to an INCREASE in total
expenditure. For an elastic good, an increase in price leads to a DECREASE in total expenditure.

67



Pr oof t. x F( p) /. /. ..-. /. / /. ,. ... .., :/. /
.,.... ,. p
:c; APPLICATIONS TO ECONOMICS 5
0
a/ 2b a/ b
E( p) = p - x = p - F{ p) .
: .. ././. E( p) ., ..., .. ... /, /./ /. ,
/ / ..... o, /. t.. t./.
E' ( p) = p F' ( p) + 1 F( p) .
t... // .. /, /. pos i t i ve ., F( p) :
E' ( p) _ p F' { p)
: . :
F{ p)
by (9). t/ /. ,. ./ 1 < e < . e + : t / . :
,.. E' ( p) ,.. . /../. E( p) ., /. / p.
s-//, / /. ,. ./ e < : . e + : . ./ .,.
: .,.. E' ( p) .,.. . /../. E{ p) ..., /. /
p.
t ./, ./ .. .- -../ .- -.-. .. ,./
/./ /- / /. .-, ..-. /. .,.//, linear demand
x F( p) = a bp, a, b >
. constant elasticity demand
x = F( p) = kp~
r
, k, r >0 .
::
::
t :: /. ..-. /. ,/ /. .,-. ./ .,.. /,. b
.
..,
a,
,...
t,..
::
s. /.
/,. / F
.//.
/-
The gr aph of t he l i near demand f unct i on x = a
bp.

Figure
3.20
:
F( p)
cs ONE-VARIABLE CALCULUS: APPLICATIONS [3]

the elasticity of F, it should not be surprising that the elasticity varies along the demand curve:
_ F'(p) p _ -bp s =
F(p) a bp 1 (a/bp)
from e = 0 whenp = 0 and je = a to e =
30
when p = a/b and x = 0.
In Figure 3.20, the graph of the demand function x = F(p) is drawn in what appears to be the most natural
way with the independent variable p measured along the horizontal axis and the dependent variable x
measured along the vertical axis. However, for all the other quantity-price relationships we have studied so far
cost, revenue, profit, and their marginal and average manifestations the output x was naturally the
independent variable and was represented along the horizontal x-axis while the price variable was naturally
the dependent variable and was represented along the vertical y-axis. Because this use of the horizontal and
vertical axes is the more common situation for economic functions and because we will want to incorporate the
demand relationship into our graphical studies of revenue, cost, and profit curves, as in Figure 3.19, as average
revenue curves, we will graph the demand relationship with quantity on the horizontal axis and price on the
vertical axis.
This section concludes with the incorporation of the demand, average revenue, and marginal revenue curves
into our analyses of the cost curves in Figure 3.18. This was done in Figure 3.19 for the case of perfect
competition where the average revenue curve was a horizontal line. Now treat the antipodal case of a pure
monopolist facing a linear demand curve x = a bp for its product. The inverse demand curve is

P=L-\X. (B)

If the monopolist wants to sell x units, it will have to charge the price p given by (13). Therefore, the
monopolist's revenue function is
R(x)
The marginal revenue is
IL-I")"

a curve with the same /^-intercept but with twice the slope of the average revenue (= inverse demand)
curve. These curves are sketched in Figure 3.21. The optimal output occurs at the point x* above which the
MR- and MC-curves cross. The corresponding selling price p* can be read off the demand curve above x*
(not from
[3.6] APPLICATIONS TO ECONOMICS c.

theMft-curve). One can use Figure 3.21 to show, for example, that if manufacturing costs increase so that
the MC-curve rises, then output will decline and price will rise.

EXERCISES
3.15Show that the function f(x) = x
3
+ x + 1 has the essential properties of a cost
function. Carefully graph its corresponding average cost function and marginal cost
function on the same coordinate axes and compare your answer with Figure 3.18.
3.16What happens to a competitive firm whose cost function exhibits decreasing
marginal cost everywhere? Construct a concrete cost function of this type and carry out
the search for the profit-maximizing output.
3.17a) Which rectangle in Figure 3.19 has an area equal to the firm's optimal revenue
atx = x*l
b)Using the fact that AC(x) = C(x)/x and therefore C{x) = AC{x) x, find the rectangle
whose area gives the total cost of output x*.
c) Which area in Figure 3.19 represents the firm's optimal profit?
3.18Prove that the point elasticity is 1 exactly at the midpoint of the linear demand
in Figure 3.20.
3.19Compute the point elasticity for the demand function (12) and conclude why (12) is
called the constant elasticity demand.
3.20What happens to x* and p* if the demand curve rises in Figure 3.21?
3.21Indicate carefully the rectangle in Figure 3.21 whose area gives the monopolist's
profit.
3.22For F(p) = a bp and C(x) = kx
2
, calculate explicitly the formula for the
optimal output and its price.