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 makers 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
will look 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, which 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, and so 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
|
Price
|
Quantity
|
Marginal Revenue
|
$3.00
|
1
|
.
|
.
|
$1.00
|
$2.00
|
2
|
.
|
.
|
-$1.00
|
$1.00
|
3
|
.
|
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
Economists generally assume that the demand curve is
fixed, but many businesses do not regard it that way. It can
vary seasonally, with the general level of business
activity, or with a trend. The demand for turkeys has a
pronounced seasonal movement. The demand for automobiles
changes when there is a recession. The demand for baby food
follows the trends in birth rate.
Business also may be able to move its demand curve
through advertising. Advertising may simply give people
information, it may change their goals, or it may change
their perception of the product. For the firm it does not
matter which happens. The result is the same--good
advertising moves the demand curve to the right.
The demand curve can move for other reasons. 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.
The firm may also be able to change its demand curve by
changing the characteristics of its product.
Finally, many firms sell several products that may be
interrelated, and any pricing decision on one product will
have effects not only on that product but also on others.
For example, the prices that General Motors charges for
Chevrolets will affect the demand curve for Pontiacs.
1We have discussed the demand
curve as a boundary, but a special case of price
discrimination may occasionally 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 very difficult to find examples of
firms trying to reach the "all-or-nothing" demand curve.
This behavior is most likely to occur only in markets with
one seller and few buyers, markets in which prices are set
in a bargaining process.
Copyright
Robert Schenk
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