Chapter 7 (2)

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Unit 7

Unit 8

Unit 9

Unit 10

Unit 11

Unit 12

Unit 13

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. If the marginal cost is lower than the price, the firm receives a surplus too

The price elasticity of demand is a measure of the responsiveness of consumers to a price change. It is defined as the percentage change inn demand that would occur in response to a 1% increase in price

We calculate the elasticity, E, as follows:
E = - %change in demand / %change in price

This means the firms decision depends on how steep the demand curve is: in other words, how much consumers demand for a good will change if the prices change.

For a demand curve, quantity falls when price increases

The firm maximizes profit by choosing the point where the slope of the isoprofit 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.

If the government puts a tax on a particular good, the tax will raise the price paid by the consumers, so the effect of the tax will depend on the elasticity of demand:

If the 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

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

A second important reason is decreasing average costs, perhaps due to economies of scale in production, fixed costs, or input prices declining as the firm purchases larger quantities. In such cases the average cost of production is greater than the marginal cost of each unit and the average cost curve slopes downward. The price must be above the marginal cost

Firms set prices above marginal costs when the goods they produce are differentiated from those produced by other firms, so that they serve consumers with different preferences and face limited competition

Decreasing average costs mean that firms can produce at lower cost per unit when operating at a large scale. In domestic utilities there are high fixed costs of providing the supply network, irrespective of the quantity demanded by consumers. Utilities typically have increasing returns to scale

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 is firms setting prices above the marginal cost of producing their goods

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 goods 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

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 have to choose a price above the marginal cost of production - even more so when competition is limited and elasticity of demand low

The more similar the cars, the more responsive consumers will be to price differences

The manufacturer of a very specialized type of car, faces little competition and hence less elastic demand. It can set a price above marginal cost without losing customers. Such a firm is earning monopoly rents arising form its position as the only supplier of this type of car

When consumers can choose between several quite similar cars, the demand for each of there cars is likely to be quite elastic. If the price were to rise, demand would fall because people would choose to buy one of the other brands instead. If the price were to fall, demand would increase because consumers would be attracted away from the other cars

So a firm will be in a strong position if there are few firms producing close substitutes for its own brand because it daces 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 relationship what customers to set a high price without losing them to competitors

In a monopolized market there is only one seller. The firm would set a price greater than the marginal production cost

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 copy right 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

Technological innovation may provide opportunities to get ahead of competition

When products are differentiated the firm can use advertising to inform consumers about the existence and characteristics of its product attract them away from its competitors and create brand loyalty

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 competition 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 people engage voluntarily in an economic 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 the trade. We judge the total surplus and the way it is shared in terms of Parteo efficiency and fairness

The shaded area above P measures the consumer surplus, and the shaded area below P is the producer surplus. We see from the relative sizes of the two shaded ares that in this market, the firm obtains a greater surplus share

The allocation is not Pareot efficient. 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 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 buy to accept. An individual consumer has no power to bargain for a better deal because the firm has many other potential customers

The price is greater than the marginal cost, it could produce another car and sell it to the 33rd customer at a profit lower than $5440 but higher than the production cost. This would be a Pareto Improvement: both the firm and the 33rd consumer would be better off

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

The firm chooses E because that is the best it can do given the rules of the game (setting one price for all customers). The allocation that results from Price-setting by the producer of a differentiated product like Beautiful Cars is Pareto Inefficient

Since the firm choose 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 curves

The total surplus would be higher at the Pareto-efficient profit 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

To set individual prices (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

The demand curve for cars which has a constant slope: it is a straight line. At every point if the quantity increases by one (delta Q = 1), the price falls by $80 (delta P = -$80):

slope of the demand curve = - delta P / delta Q = -80
% change in Q = 100 (delta Q / Q) = 100 (1/20) = 5%
% change in P = 100 (delta P/ P) = 100 (-80/6400) - -1,25%
R = - 5/-1.25 = 4

If the demand curve is quite flat, the quantity changes a lot in response to a change in price, so elasticity is high. A steeper demand curve corresponds to a lower elasticity. Elasticity changes as we move along the demand curve even if the slope doesn't

Marginal revenue is positive at points where demand is elastic, and negative where it is inelastic

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

When demand is highly elastic, price will only fall a little if the firm increases its quantity. So by producing one more 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. If demand is inelastic the firm cannot increase Q without a big drop in P, so MR <0

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

Secondly, the firms profit margin (the difference between the price and the marginal cost of production) is closely related to the elasticity of 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. 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

Shows the decision of a firm with the same costs of car production, but less elastic demand for its product. The profit margin is high, and the quantity is low. When the price is raised, many consumers 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

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

So a government wishing to raise tax revenue should choose to tax products with inelastic demand

Firms that have few competitors. Market power allows them to set high prices and make high profits at the expense of consumers. Potential consumer 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 s a deadweight loss

Policy to limit market power and prevent cartels is known as competition policy, or antitrust policy. Dominant firms may exploit their position by strategies other than high prices

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

Advertising - Its main function was not to inform consumers about the product, but rather to increase brand loyalty, and encourage consumers of other cereals to switch

Limiting 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. A price above marginal cost results in market failure

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

The price of a differentiated product is above the marginal cost as a direct result of the firms response to the absence of competing firms and price insensitivity of consumers. The source of the problem in this case of utilities and films is the cost structure rather than lack of competition

Policymakers may not be able to induce firms to lower their prices by promoting competitors since average costs would rise with more firms in the market. They may choose instead to regulate the firms activities, limiting its discretion over prices in order to increase consumer surplus. An alternative is public ownership