The Demand Curve for Output
Once a firm has produced a product, it must sell it. The demand curve for output describes the limitations the firm faces in doing this task. The demand curve for output is a constraint on the firm because it gives the maximum price that a firm can charge for each level of production. Thus, if the firm in the graph below wants to sell 24, it can do so by charging $5.00 or any price that is lower. It cannot charge $10.00 and still sell 24 because buyers will not allow it.
The demand curve facing a firm depends both on the preferences of consumers and on how well other firms meet those preferences. One can derive a demand curve for an individual from a set of indifference curves showing the individual's preferences and a series of budget lines showing changes in price. To get a demand curve for the entire industry, one must add up all the demand curves of individuals. To get the demand curve for eggs, for example, one must add up the number of eggs that Smith and Jones and Nelson and all other consumers in the market want at each possible price.
When there is only one firm selling in a market, that firm is a monopolist. (The Greek root mono- means "one.") The demand curve for the monopolist is the demand curve for the industry. A monopolist is a price searcher or a price maker. It will search along the demand curve for the price-quantity pair that is most profitable. When there is more than one seller, the demand curve that a seller sees is not the same as the demand curve for the industry. The industry demand is split up among sellers. When there are only a few sellers, the sellers will still be price searchers or price makers. These sellers, or oligopolists (the Greek root oli- means "few"), are price searchers because each recognizes that if it wants to sell more, it must lower its price.
However, the demand curve of each oligopolist will be more elastic than the demand curve for the industry as a whole. Suppose, for example, that there are two firms in an industry, each produces 50 units of output, and the elasticity of the industry demand curve is one. If one firm increases its output by 10% to 55, the industry output increases to 105, which is a 5% increase. Since the price elasticity of demand is one, price must decline by 5%. But for the original firm, a 10% increase in production and a 5% decline in price indicate a price elasticity of two, not one.
As firms get more and more numerous in an industry, the demand curve each sees gets more and more elastic. When there are a great many sellers in the market, a change of output by any one of them has an insignificant effect on price. To each firm the demand curve appears to be perfectly flat--the firm will seem able to sell whatever amount it wants at a fixed price. In this case, each firm is a price taker and sells in a perfectly competitive market. An example of this type of market is the market for wheat. There are a great many wheat farmers in many countries, and none has any noticeable control over the price at which it can sell in the world wheat market.
However, even when there are a great many sellers, each firm may have a downward-sloping demand curve. If buyers must expend time and effort to discover prices or the characteristics of the product, they will pick a seller and stay with it as long as they find the exchange satisfactory. These downward-sloping demand curves of small sellers are a result of the ambiguous definition of industry. The products most firms produce differ in some way, such as in quality, service, or location, from the products of other firms in the industry.
From the viewpoint of the firm, it is not the demand curve, but the child of the demand curve, the marginal revenue curve, that is of vital importance. Marginal revenue is the extra revenue a seller gets when it produces and sells another unit. For the price taker the marginal revenue curve is the demand curve. For the farmer who can sell corn at $4.00 a bushel, the extra revenue from selling another bushel is $4.00. The demand curve for this farmer is flat at $4.00, as is his marginal revenue curve.
The table below illustrates why marginal revenue will be less than price for a price searcher. If the firm charges $3.00, it can sell one unit and total revenue will be $3.00. If it sells one more unit, it will be forced to cut price to $2.00 and total revenue will rise to $4.00. Selling the extra unit adds only $1.00 to revenue. Although the second unit sold for $2.00, the firm had to cut the price it was previously receiving for the first unit by $1.00, so the net increase in revenue was only $1.00. By similar logic, selling the third unit reduces total revenue by $1.00, so marginal revenue is -$1.00.
|Demand and Marginal Revenue
The previous analysis assumes that the firm can charge only one price. If it can charge more than one price, charging higher prices to those willing and able to pay them and lower prices to others, it can move the marginal revenue curve closer to the demand curve, increasing profits (or reducing losses). This pattern of pricing is called price discrimination.1
In textbooks demand curves are precise and clear. For real businesses that are price searchers, they are imprecise, largely unseen, and changeable. Past prices can influence demand curves. If a firm lowers its price and later raises it back to its previous level, it may find that sales at the old price have changed. The lower price may attract new customers who have not tried the product before and who find they like the product enough to stick with it when the old price is restored. Alternatively, some customers may expect prices to be cut again sometime in the future, and may decide to postpone purchases until it happens again. The opposite can happen if the firm temporarily raises price. It may encourage some customers to try substitutes, which they may find suit them better than the original product. Or it may encourage customers to buy more when the price comes down to prepare for any future increase.
Many businesses can move their demand curves. They can change consumer behavior by changing the characteristics of their products. They also advertise. Advertising may change people's goals, it may change their perception of the product, or it may simply give people information. For the firm it does not matter which happens. The result is the same--good advertising moves the demand curve to the right.
Finally, pricing decisions may be complicated when a firm has several related products. The price of one product can
affect not only sales of that product but also of other products. For example, the prices that General Motors charges for Chevrolets may affect the demand curve for Buicks.
The third and final boundary the firm faces is the supply curve for resources.
1We have discussed the demand curve as a boundary, but a special case of price discrimination may allow a seller to get to the right of the demand curve to another curve called the "all-or-nothing demand curve." Suppose that the seller in the table above tells the buyer that he has a choice, either nothing or three units for $1.90 each. The buyer would be better off buying three rather than none because the total value of the three is $6.00. Recall that the demand curve tells the marginal benefit to the consumers. The first unit is worth $3.00, the second is worth an added $2.00, and the third one is worth an added $1.00, for a total of $6.00. At $1.90 each, the three cost $5.70, so the buyer will buy them. He would prefer only two at $1.90 each, but that option is not open to him.
It is difficult to find examples of firms trying to reach the "all-or-nothing" demand curve. This behavior is most likely to occur with one seller and few buyers, markets where prices are set in a bargaining process.
Copyright Robert Schenk