Transcript ch7

Economics: Theory Through Applications
7-1
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Chapter 7
Where Do Prices Come From?
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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?
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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?
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The Goal of a Firm
Profit  Revenues  Costs
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Figure 7.1 - A Spreadsheet That Would Make
Pricing Decisions Easy
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Figure 7.2 - A Change in Price Leads to a
Change in Profits
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Figure 7.3 - The Profits of a Firm
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The Goal of a Firm
Profit  Revenues  Costs
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The Revenues of a Firm
Revenues  Price  Quantity
Revenues  15  25, 000  $375, 000
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Figure 7.4 - A Change in the Price Leads to a
Change in Demand
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The Demand Curve Facing a Firm
Quantity demanded  100  5  price 
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Table 7.1 - Example of the Demand Curve
Faced by a Firm
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The Demand Curve Facing a Firm
Quantity demanded
 20  Price
5
Price = 20 
Quantity demanded
5
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Figure 7.5 - Two Views of the Demand Curve
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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
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Figure 7.6 - The Elasticity of Demand
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The Elasticity of Demand: How Price
Sensitive Are Consumers?
Quantity demanded  100  500  Price
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Figure 7.7 - The Elasticity of Demand When
the Demand Curve Is Linear
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Figure 7.8 - Finding the Demand Curve
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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
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Figure 7.9 - Revenues
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Table 7.2 - Calculating Revenues
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Figure 7.10 - Revenues Gained and Lost
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Figure 7.11 - Calculating the Change in
Revenues
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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 
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Marginal Revenue and the Elasticity of
Demand


1
Marginal revenue  price  1 

 (Elasticity of demand) 
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Figure 7.12 - Marginal Revenue and Demand
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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) 
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Figure 7.13 - Marginal Revenue and the
Elasticity of Demand
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Table 7.3
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Marginal Cost
Marginal cost 
Change in cost
Change in quantity
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Figure 7.14 - Marginal Cost
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Table 7.4 - Marginal Cost
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Figure 7.15 - An Example of a Cost Function
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Figure 7.16 - Changes in Revenues and Costs
Lead to Changes in Profits
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Figure 7.17 - Setting the Price or Setting the
Quantity
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Figure 7.18 - Optimal Pricing
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Markup Pricing: Combining Marginal Revenue
and Marginal Cost
Marginal revenue  Marginal cost
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The Markup Pricing Formula
Price  (1  Markup)  Marginal cost
Markup 
1
(Elasticity of demand)  1
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Figure 7.19 – A Price Algorithm
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Figure 7.20 - The Demand Curve Facing a
Firm in a Perfectly Competitive Market
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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
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Table 7.5 - Costs of Production: Increasing
Marginal Cost
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Figure 7.21 - The Supply Curve of an
Individual Firm
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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
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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
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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
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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
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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
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