Robin Naylor, Department of Economics, Warwick 1 Topic 2: Firm Behaviour Lecture 11 The circular...

Robin Naylor, Department of Economics, Warwick

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Topic 2: Firm Behaviour Lecture 11

•The circular flow model once more

Agent:

Households

Market:

Goods/Services

Market:

Inputs

Agent:

Firms

Demand

Demand

Supply

Supply


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Topic 2 Lecture 11

Economic Profit, Revenue and Cost

Firm Objective: Profit-maximisation

Profit = Total Revenue – Total Cost

(Normal Profit if TR – TC = 0)

Total Cost includes the Opportunity Costs of the Owner (and hence is one reason for definitions of costs and profits to vary from the accountant’s definition)

Let’s look first at Revenues and then at Costs


3

Revenues

The Firm’s Revenues depend on the Demand Curve it faces:

p=p(X)

e.g.: p = a – bX

Total Revenue is given by

TR = p(X)X

e.g.: TR = (a – bX)X = aX – bX2 Now draw the TR curve.

Topic 2 Lecture 11


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Topic 2 Lecture 11Revenues

TR = (a – bX)X = aX – bX2

Now draw the TR curve.

X

X

p

TR

TR Why does the TR curve rise and then fall . . . ?


5



X

X

p

TR

TR

D

This has to do with price elasticity of demand . . .

Demand is elastic

Demand is inelastic

X=a/2b


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Topic 2 Lecture 11

2

First note that for the linear case:

.

( )So, TR is maximised when 0.

( )2 .

( )0 2 0 / 2 .

( )What is the name we give to ?

TR aX bX

d TR

dXd TR

a bxdXd TR

a bX X a bdX

d TR

dX


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X

X

p

TR

TR

D

Demand is elastic

Demand is inelastic

X=a/2b

MR MR = a – 2bX


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Topic 2 Lecture 11Next, recall that:

.

In the general case, ( ) and hence:

( ) .

( ) ( )So, ( ) .

Or, .

Re-arranging terms, 1 .

1Or, 1 .

dX p

dp X

p p X

TR pX p X X

d TR dX dp XMR p X X

dX dX dXdp

MR p XdX

dp XMR p

dX p

MR p


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Topic 2 Lecture 11

1So, 1 .

In other words, is maximised when 0, which is when 1.

Suppose demand is elastic ( 1): then we are in the upper part of the demand curve

(look back at the diagram to see t

MR p

TR MR

his).

What happens if the firm lowers its price in order to sell an unit of ?

There are two effects on :

(i) + ve effect: an additional unit is sold at the new price ,

(ii) ve effect: the price of

X

TR

p

each unit sold is now lower than previously.

Identify these 2 effects in terms of the equation for ;

.

If demand is elastic, then only a small price reduction is needed to sell an extra unit

MR

dpMR p X

dX

,

and the ve effect is relatively weak: the +ve effect dominates and 0 ( ) when 1.MR TR


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Topic 2 Lecture 11Now consider what happens in the lower portion of the demand curve, where demand is inelastic.

1Recall that: 1 .

Suppose demand is inelastic ( 1): then we are in the lower part of the dema

MR p

nd curve

(look back at the diagram to see this).



(i) + ve effect: an additional unit is sold at the

X

TR

new price ,

(ii) ve effect: the price of each unit sold is now lower than previously.

.

If demand is inelastic, then a large price reduction is needed to sell an extra unit,

and the ve effe

p

dpMR p X

dX

ct is relatively great: it dominates and 0 ( ) when 1.MR TR


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Topic 2 Lecture 11

Finally, consider what happens when demand is unit elastic.

1Recall that: 1 .

Suppose demand is unit elastic ( 1): then we are at the mid-point of the linear demand curve

(look back at the

MR p

diagram to see this).



(i) + ve effect: an additional unit is sold at the new price ,

(ii) ve effe

X

TR

p

ct: the price of each unit sold is now lower than previously.

.

If demand is unit elastic, then the + ve effect and the ve effect are just equal: 0 ( is unchanged) when 1.

dpMR p X

dXMR TR


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X

X

p

TR

TR

D

Demand is elastic

Demand is inelastic

X=a/2b

MR

The relationships between:

Demand

TR

MR

should all now be clear to you.


Topic 2: Lecture 11

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Now read B&B 4th Ed., pp. 444-447; 451-452; 455

(but don’t worry about issues (especially the mathematical material) which go beyond what you have seen in lecture notes or seminar exercise sheets)

Note that on these pages, B&B often refer to the firm as a ‘monopolist’ while in my lectures I do not use the term ‘monopolist’ – I simply refer to ‘the firm’. Implicitly, I’m talking about a monopoly firm because I’m assuming that there is just one firm in the market (notice that I never refer to the existence of competitor firms). A firm is a monopolist when there are no other firms supplying output in the market.

Robin Naylor, Department of Economics, Warwick 1 Topic 2: Firm Behaviour Lecture 11 The circular...

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