24 • Economics Primer: Basic Principles

•The product is used in conjunction with another product that buyers have committed themselves to. For example, an owner of a copying machine is likely to be fairly insensitive to the price of toner, because the toner is an essential input in running the copier.

Brand-Level versus Industry-Level Elasticities

Students often mistakenly suppose that just because the demand for a product is inelastic, the demand facing each seller of that product is also inelastic. Consider, for example, gasoline. Many studies have documented that the demand for gasoline is price inelastic, with elasticities of around 0.10–0.20. This suggests that a general increase in the prices charged at all gas stations would only modestly affect overall gasoline demand. However, if only one gas station increases its price, the demand for that gas station would probably drop substantially because consumers would patronize other stations. Thus, while demand can be inelastic at the industry level, it can be highly elastic at the brand level.

Should a firm use an industry-level elasticity or a firm-level elasticity in assessing the impact of a price change? The answer depends on what the firm expects its rivals to do. If a firm expects that rivals will quickly match its price change, then the industry-level elasticity is appropriate. If, by contrast, a firm expects that rivals will not match its price change (or will do so only after a long lag), then the brandlevel elasticity is appropriate. For example, Pepsi’s price cut succeeded because Coke did not retaliate. Had Coke cut its price, the outcome of Pepsi’s strategy would have been different. Making educated conjectures about how rivals will respond to pricing moves is a fascinating subject. We will encounter this subject again in Chapter 5.

TOTAL REVENUE AND MARGINAL REVENUE FUNCTIONS

A firm’s total revenue function, denoted by TR(Q), indicates how the firm’s sales revenues vary as a function of how much product it sells. Recalling our interpretation of the demand curve as showing the highest price P(Q) that the firm can charge and sell exactly Q units of output, we can express total revenue as

TR(Q) 5 P(Q)Q

Just as a firm is interested in the impact of a change in output on its costs, it is also interested in how a change in output will affect its revenues. A firm’s marginal revenue, MR(Q), is analogous to its marginal cost. It represents the rate of change in total revenue that results from the sale of DQ additional units of output:

MR(Q) 5

TR(Q 1 DQ) 2 TR(Q)

DQ

It seems plausible that total revenue would go up as the firm sells more output, and thus MR would always be positive. But with a downward-sloping demand curve, this is not necessarily true. To sell more, the firm must lower its price. Thus, while it generates revenue on the extra units of output it sells at the lower price, it loses revenue on all the units it would have sold at the higher price. Economists call this the revenue destruction effect. For example, an online electronics retailer may sell 110 DVDs per day at a price of $11 per disc and 120 DVDs at $9 per disc. It gains additional

26 • Economics Primer: Basic Principles

THEORY OF THE FIRM: PRICING AND OUTPUT DECISIONS

Part Two of this book studies the structure of markets and competitive rivalry within industries. To set the stage for this analysis, we need to explore the theory of the firm, a theory of how firms choose their prices and quantities. This theory has both explanatory power and prescriptive usefulness. That is, it sheds light on how prices are established in markets, and it also provides tools to aid managers in making pricing decisions.

The theory of the firm assumes that the firm’s ultimate objective is to make as large a profit as possible. The theory is therefore appropriate to managers whose goal is to maximize profits. Some analysts argue that not all managers seek to maximize profits, so that the theory of the firm is less useful for describing actual firm behavior. An extensive discussion of the descriptive validity of the profit-max- imization hypothesis would take us beyond this primer. Suffice it to say that a powerful “evolutionary” argument supports the profit-maximization hypothesis: if, over the long haul, a firm’s managers did not strive to achieve the largest amount of profit consistent with industry economics and its own particular resources, the firm would either disappear or its management would be replaced by one that better served the owners’ interests.

Ideally, for any given amount of output the firm might want to sell, it would prefer to set price as high as it could. As we have seen, though, the firm’s demand curve limits what that price can be. How, then, is the optimal output determined? This is where the concepts of marginal revenue and marginal cost become useful. Recalling that “marginals” are rates of change (change in cost or revenue per oneunit change in output), the change in revenue, cost, and profit from changing output by DQ units (where DQ can either represent an increase in output, in which case it is a positive amount, or a decrease in output, in which case it is a negative amount) is

Change in Total Revenue 5 MR 3 DQ

Change in Total Cost 5 MC 3 DQ

Change in Total Profit 5 (MR 2 MC) 3 DQ

The firm clearly would like to increase profit. Here’s how:

•If MR . MC, the firm can increase profit by selling more (DQ . 0), and to do so, it should lower its price.

•If MR , MC, the firm can increase profit by selling less (DQ , 0), and to do so, it should raise its price.

•If MR 5 MC, the firm cannot increase profits by either increasing or decreasing output. It follows that output and price must be at their optimal levels.

Figure P.10 shows a firm whose output and price are at their optimal levels. The curve D is the firm’s demand curve, MR is the marginal revenue curve, and MC is the marginal cost curve. The optimal output occurs where MR 5 MC, that is, where the MR and MC curves intersect. This is output Q* in the diagram. The optimal price P* is the associated price on the demand curve.