CLASS 5: THE FIRM AND ITS CUSTOMERS

Index:
Costs / Revenue /Profit
Profit Maximization
Surplus
Price Elasticity of demand

Profitability determines the success of a firm and its ability to grow, and to study it we need to
determine what way firms decide output prices.
The simplified version of a firm is that it wants to maximize profits.
➔ Profit= revenue - cost
Constrained problem: Feasible combinations of output prices and quantities depend on consumer
demand (and technology).

1. Costs
Costs are an essential element of profit maximization. Managers need to know cost functions to make
pricing and production decisions.
➔ The total cost depends on the amount of output produced. They can be decomposed in fixed
and variable costs.
It is also important to distinguish between two cost concepts:
● Average Costs : which measure how much it costs, on average, to produce one unit.
Geometrically, the AC is the slope of the line that connects the origin to a given point of the
total cost function. Usually U-shapped.

For a given Q, the profit per unit is such that:

● Marginal Costs: additional cost incurred by increasing production. Geometrically, the MC is

the slope of the line tangent to the total cost function in a specific point. Mostly upward
sloping. It's crucial to determine the level of profit-maximizing output.
 2. Revenue

➔ Where P(Q) is the inverse demand function (prices as a function of quantity).

➔ The marginal revenue (MR) measures the impact of changing quantities on total revenue. MR
reflects the tension between the price and the quantity

Demand curve: the demand curve measures the quantity that consumers will buy at each price. It has a
negative slope.
Inverse demand function: consumer willingness to buy.
Price elasticity of demand: measures the degree of responsiveness of demand to a price change.
➔ Changing output on Revenue is not always the same (increasing output can also lead to
decreasing revenue): The PED typically varies along the whole function although it is a
straight line.
➔ PED measures the change in the demand whenever there is a change in the price.
➔ The formula is negative so the answer is positive.
➔ If by increasing the quantity and lowering the price the enterprise still has more revenue, then
the firm should increase the quantity.
➔ People are very reactive to price changes so when the elasticity of demand is larger than one,
then the revenue is positive. When the elasticity is between zero and one, the revenue is
negative.

Example

3. Profit

➔ Profit= revenue - cost = price x quantity - cost

Isoprofit curves represent the different quantities-prices combinations which yield the same profit
level.The further away from the origin represent higher profit levels.
● Slope of the isoprofit depends on the cost structure of the firm

● To keep profit constant we increase Q and decrease P by

 4. Profit maximization
The firm must target the highest isoprofit curve, which still includes at least one feasible bundle in
terms of consumer demand.
● Demand curve = Firm’s feasible frontier [slope = MRT]
● Isoprofit curves = combinations that yield the same profit. [slope =MRS].
● In equilibrium, MRS=MRT or MR=MC → Point E is the last feasible point in the highest
isoprofit.
● Profit-maximization can also be described in terms of revenues and costs.
● When firms change output (change in Q), revenue changes (MR) and costs also change (MC).

5. Surplus
In a market economy both firms and consumers affect equilibrium outcome (quantities and prices), the
consumer willingness to pay restricts the firms’ profit maximization targets.
➔ Consumer surplus (CS) is the total difference between willingness to pay and market price.
➔ Producer surplus (PS) = Revenue - MC
➔ Total surplus (TS)=CS + PS. The maximum total surplus is attained under the equilibrium in
competitive markets (D= MC) → Pareto efficient allocation
Pareto efficient allocation is the improvement of one person by making the other person worse. In
some cases, the Pareto efficient allocation cannot be attained, reducing potential gains from trade and
generating a Deadweight loss.
● Deadweight loss
(DWL) is the loss in
total surplus relative to
a Pareto efficient
allocation. If DWL> 0,
there are unexploited
gains from trade. This
is common when firms
have market power (for
instance, a monopolist)
When we move point E to the left, we increase the producer surplus, which happens when the market
power of the firm increases and it is worse for the consumer. That point wouldn't be equilibrium
because there is no proportion between both. Obviously, this is better for the company but worse for
the people.

6. Price elasticity
The profit margin as a proportion of the price is inversely proportional to price elasticity of demand.
➔ When the demand is elastic and the demand curve is flatter, the firm has less power to move
prices because the people would react violently to prices. The profit margin of the firm is low.
➔ When the demand is inelastic and the demand curve is steeper, the firm has more power to
change prices because the people react less to price changes. The profit margin for the
enterprise is higher. Ex: electricity

● A firm’s profit margin depends on the elasticity of demand, which is determined by

competition. Demand is relatively inelastic if there are few close substitute goods.
● Firms with market power can set prices above marginal cost (bargaining power) without
losing customers to competitors. This is a form of market failure → generates DWL.
● Governments can hire Independent authorities to regulate competition, and if this fails, they
impose maximum prices.
● Many firms have market power in the shape of products as many similar goods have different
prices, which can be reached through differentiation (innovation, advertising…)
Examples of firms with market power: specialized products sellers (no substitutes), monopolies (only
one firm produces and supplies a good to the market) and Natural monopolies (firm produces at lower
average cost than the others)

The elasticity matters also for taxes. If the tax is placed on an elastic market, where the consumer is
very reactive to prices, then the consumption will drop a lot.

Government raises more tax revenue by levying taxes on price-inelastic goods, where consumers are
less sensitive to price changes (demand more vertical).
The government also can put taxes with additional policy goals:
● Taxes on gas, or plastic bags also aim at mitigating climate change
● Taxes on sugar or fat should incentivize consumers to eat in a more healthy manner