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Economics: Theory Through Applications 7-1 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA 7-2 Chapter 7 Where Do Prices Come From? 7-3 Learning Objectives • What is the goal of a firm? • What is the demand curve faced by a firm? • What is the elasticity of demand? How is it calculated? • What is marginal revenue? • What is marginal cost? • What costs matter for a firm’s pricing decision? 7-4 Learning Objectives • What is the optimal price for a firm? • What is markup? • What is the relationship between the elasticity of demand and markup? • What is a perfectly competitive market? • In a perfectly competitive market, what does the demand curve faced by a firm look like? • What happens to the pricing decision of a firm in a perfectly competitive market? 7-5 The Goal of a Firm Profit Revenues Costs 7-6 Figure 7.1 - A Spreadsheet That Would Make Pricing Decisions Easy 7-7 Figure 7.2 - A Change in Price Leads to a Change in Profits 7-8 Figure 7.3 - The Profits of a Firm 7-9 The Goal of a Firm Profit Revenues Costs 7-10 The Revenues of a Firm Revenues Price Quantity Revenues 15 25, 000 $375, 000 7-11 Figure 7.4 - A Change in the Price Leads to a Change in Demand 7-12 The Demand Curve Facing a Firm Quantity demanded 100 5 price 7-13 Table 7.1 - Example of the Demand Curve Faced by a Firm 7-14 The Demand Curve Facing a Firm Quantity demanded 20 Price 5 Price = 20 Quantity demanded 5 7-15 Figure 7.5 - Two Views of the Demand Curve 7-16 The Elasticity of Demand: How Price Sensitive Are Consumers? Elasticity of demand Percentage change in quantity Percentage change in price (Elasticity of demand) Percentage change in quantity Percentage change in price Quantity demanded 100 5 Price 7-17 Figure 7.6 - The Elasticity of Demand 7-18 The Elasticity of Demand: How Price Sensitive Are Consumers? Quantity demanded 100 500 Price 7-19 Figure 7.7 - The Elasticity of Demand When the Demand Curve Is Linear 7-20 Figure 7.8 - Finding the Demand Curve 7-21 Measuring the Elasticity of Demand Quantity demanded 252 300 Price Quantity demanded 252 300 0.5 102 (Elasticity of demand) Percentage change in quantity 14.7 1.47 Percentage change in price 10 7-22 Figure 7.9 - Revenues 7-23 Table 7.2 - Calculating Revenues 7-24 Figure 7.10 - Revenues Gained and Lost 7-25 Figure 7.11 - Calculating the Change in Revenues 7-26 Marginal Revenue Change in revenues Change in quantity New price (Change in price Initial quantity) Marginal revenue Change in revenue Change in quantity Percentage change in price Marginal revenue price 1 Percentage change in quantity 7-27 Marginal Revenue and the Elasticity of Demand 1 Marginal revenue price 1 (Elasticity of demand) 7-28 Figure 7.12 - Marginal Revenue and Demand 7-29 Marginal Revenue and the Elasticity of Demand 1 2 1 Marginal revenue price 1 15 1 15 10 3 3 (Elasticity of demand) (Elasticity of demand) Percentage change in quantity 1 Percentage change in price 1 1 Marginal revenue price 1 10 1 10 0 0 1 (Elasticity of demand) 7-30 Figure 7.13 - Marginal Revenue and the Elasticity of Demand 7-31 Table 7.3 7-32 Marginal Cost Marginal cost Change in cost Change in quantity 7-33 Figure 7.14 - Marginal Cost 7-34 Table 7.4 - Marginal Cost 7-35 Figure 7.15 - An Example of a Cost Function 7-36 Figure 7.16 - Changes in Revenues and Costs Lead to Changes in Profits 7-37 Figure 7.17 - Setting the Price or Setting the Quantity 7-38 Figure 7.18 - Optimal Pricing 7-39 Markup Pricing: Combining Marginal Revenue and Marginal Cost Marginal revenue Marginal cost 7-40 The Markup Pricing Formula Price (1 Markup) Marginal cost Markup 1 (Elasticity of demand) 1 7-41 Figure 7.19 – A Price Algorithm 7-42 Figure 7.20 - The Demand Curve Facing a Firm in a Perfectly Competitive Market 7-43 Perfectly Competitive Markets Markup 1 1 0 (Elasticity of demand) 1 Price 1 Markup Marginal cost Marginal cost Marginal revenue Marginal cost Price Marginal cost 7-44 Table 7.5 - Costs of Production: Increasing Marginal Cost 7-45 Figure 7.21 - The Supply Curve of an Individual Firm 7-46 Key Terms • Profits: Revenues minus costs • Revenues: What a firm receives for selling its output, which is equal to the price received per unit sold times the number of units sold • Costs: The payments a firm makes for its inputs, such as wages for its workers • Choke price: The price above which no units of the good will be sold • Own-price elasticity of demand: The percentage change in quantity demanded of a good divided by the percentage change in the price of that good 7-47 Key Terms • Market power: The extent to which a firm produces a product that consumers want very much and for which few substitutes are available • Marginal revenue: The extra revenue from selling an additional unit of output, which is equal to the change in revenue divided by the change in sales • Marginal cost: The extra cost of producing an additional unit of output, which is equal to the change in cost divided by the change in quantity 7-48 Key Terms • Markup: The price over marginal cost, which is equal to (1 + markup) × marginal cost • Individual supply curve: How much output a firm in a perfectly competitive market will supply at any given price – It is the same as a firm’s marginal cost curve Key Takeaways • The objective of a firm is to maximize its profit, defined as revenues minus costs • The demand curve tells a firm how much output it can sell at different prices • The elasticity of demand is the percentage change in quantity divided by the percentage change in the price • Marginal revenue is the change in total revenue from a change in the quantity sold 7-50 Key Takeaways • Marginal cost measures the additional costs from producing an extra unit of output • It is only the change in costs—marginal cost—that matter for a firm’s pricing decision • At the profit-maximizing price, marginal revenue equals marginal cost • Markup is the difference between price and marginal cost, as a percentage of marginal cost 7-51 Key Takeaways • The more elastic the demand curve faced by a firm, the smaller the markup • A perfectly competitive market has a large number of buyers and sellers of exactly the same good • In a perfectly competitive market, an individual firm faces a demand curve with infinite elasticity • In a perfectly competitive market, the firm does not set a price but chooses a level of output such that marginal cost equals the market price 7-52