UNIT 7 TEACHING GUIDE UNIT 7 TEACHING GUIDE. Introduction. This is the first of four units about markets. How firms prosper

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1 UNIT 7 TEACHING GUIDE Introduction This is the first of four units about markets. How firms prosper This unit looks at how firms use pricing to maximise their profits. You will be used by now to seeing data and narrative at the opening of each unit. In this case, Figure 7.1 harks back to the hockey-stick shape familiar from Unit 1. Here, the topic is firm size and the upturn occurs for most firms in the figure around the 1970s and 1980s. The point is not that firms are all large, but that large firms are predominant employers and visible in modern (especially rich) economies. The question is why, and how, firms prosper and grow like this. Unit 2 gave part of the answer, where cost advantages that come from innovation lead to innovation rents, which in turn allow firms to earn higher profits. It would be a useful exercise to ask students why the firms in Figure 7.1 grew so rapidly in the late 20th century, and why Ford s history was different. Price-setters, not price-takers Unlike many standard introductory texts, The Economy discusses price-setting firms, such as the large firms in the introduction, before price-taking firms (this is in Unit 8). It presents price-setting as the norm, rather than a special case. This will match the experience of students who will be familiar with price-setting firms. Parama Chaudhury UNIVERSITY COLLEGE LONDON Alvin Birdi UNIVERSITY OF BRISTOL Students are not asked, as they are standard texts, to suspend their disbelief and engage with a perfectly competitive case that is far removed from their dayto-day experience. It should be relatively easy for instructors to illustrate the themes in this unit using example firms that students will know. Empirical approach This approach is also consistent with CORE s pedagogy of motivating the model with empirical context and data. The first demand curve students see (Figure 7.3) is estimated. Having understood the analytics of price-taking firms who have some power in the market, it is relatively straightforward to imagine what would happen in the extreme case where firms lose all their power. Thus, the perfect competition model is seen as a limiting (and less relevant) case where firm power is reduced completely, rather than as the key benchmark model. This is a significant change in the approach to teaching the theory of the firm. Figure 7.2 in the introduction is easily overlooked, but it is very useful to give students this overview of the firm s decisions. Students have already studied some of these decisions: In Unit 2, students were introduced to how firms decide on technologies based on cost considerations. In unit 6 the decision was what wage to set. 1

2 This unit looks at another decision: setting a price. It should be clear that, in CORE, firms (like individuals and governments) are actors that make active decisions. Two approaches to profit maximisation A novel feature of the unit is that profit maximisation uses the same indifference curve and feasible set structure that students have already seen in Units 3, 5 and 6. This enables instructors to emphasise once again that the optimal position will be a tangency (if there is an interior solution) between indifference curves and the feasible set. In this case, the firm s isoprofit curves are the indifference curves, and the feasible set is bounded by the demand curve. Students who have studied the firm before, or who look at other texts, will recognise the usual MR = MC characterisation of the profit maximum. This familiar approach misses the opportunity to emphasise the common structure of the variety of optimisation decisions and a key pedagogical advantage is lost. The economic intuition behind the isoprofit and demand curve structure is clearer than the MR = MC condition, and it is advisable to prioritise the isoprofit condition rather than MR = MC when teaching this unit. Consumer and producer surplus In keeping with the approach of CORE, economic rents are emphasised in this unit in the form of consumer surplus and producer surplus (section 7.7). In seeking rents, the firm adjusts its price towards the profit-maximising level. This model provides a very good opportunity to highlight that the outcome of an optimisation decision (the firm sets the price to maximise its profits) is an equilibrium, but not a Pareto-efficient one. Interactive Figures 7.13 and 7.14 are useful to dispel a common confusion among students that a situation is Pareto efficient because the firm is maximising profits. The inefficiency here is related to power and the rules of the game (all consumers must be charged the same price). These aspects are rarely discussed in this way in other texts. What this unit contributes to the main themes Politics and policy Section 7.9 contains a discussion of how governments make use of elasticity in designing tax policy. Section 7.10 has a discussion on imperfect competition, which naturally lends itself to a focus on antitrust/competition regulation. Innovation Cost curves are introduced in this unit, involving a discussion about the choice of technology and the effect of innovation. Section 7.11 has a discussion of product innovation. 2

3 Links from previous units Unit 2 A firm s choice of technique is first discussed in Unit 2 using a relatively straightforward production structure. The firm s decision about wages is formalised in unit 6 and this unit continues with pricing decisions. Unit 3 The production function is introduced in Unit 3, and links directly to the profit maximisation problem analysed in Unit 7. Unit 6 The link to unit 6 is particularly strong as in that unit, we discussed the firm s decision in terms of what wage to set, whereas in Unit 7, we are discussing profit maximisation in terms of what price to set (and therefore how much to produce). This is also a good stage to reiterate the point that the firm has some power in setting both prices and wages, but is constrained by how the actors in the goods market (customers, via the demand curve) and the labour market (employees, via the effort best response function), respectively, react to these choices. Links to future units Unit 8 Unit 8 discusses price-taking markets, and uses the ideas of cost curves, demand elasticity and profit maximisation developed in unit 7. Units 9 and 15 Price-setting firms are central to the wage-setting curve / price-setting curve model of equilibrium unemployment introduced in Unit 9 and used to discuss inflation (and monetary policy) in Unit 15. What's important or difficult? Isoprofit curves Note that the first time we see an isoprofit curve is directly after a graph of the empirical (and convex) Apple-Cinnamon Cheerios demand curve. Elsewhere the demand curve is linear. The zero isoprofit curve is the average cost curve so this is flat in the first example (Cheerios) and U-shaped in the second example (cars). The shape of the cost curve affects the shape of the isoprofit curves. It is useful to draw the attention of students to this. Conveying the logic of the isoprofit curve is easiest initially in the constant cost case: given the cost, if the firm lowers the price, how many more units must it sell to keep total profits unchanged? Compare the situation at a high and a low price. When the price is already close to the cost, the firm will have to sell many more units to keep profits unchanged if it reduces the price by a given amount hence, the isoprofit curve is very flat. Teachers may want to spend extra time on developing the intuition behind the isoprofit curve in price-quantity space. 3

4 Feasible set/frontier The idea of the demand curve as the frontier of the firm s feasible set is easy for students to grasp. Distinction between average and marginal cost The best way to deepen understanding here is probably to have students compute both marginal and average cost from a schedule of quantity and costs (something similar to the schedule in Exercise 7.3, but with students having to compute the AC and MC), and to explain the relationship in their own words. Elasticity This concept can be confusing to some students, because it is a measure of proportional change, and has no units. Motivate them by demonstrating how useful the measure can be. Many students believe that the elasticity is the same at any point along a straight-line demand curve, because the slope remains constant. Use interactive figure 7.15 in class, or get students to do the calculations. Using teaching resources Leibnizes The unit has five Leibnizes, which provide useful explanatory notes. The second of these is probably the most useful to clarify concepts that students might find tricky. The others provide useful extensions for more mathematically oriented courses or students: L7.3.1 Average and marginal costs: Related to section 7.3, this note looks at the mathematics of the production function for the firm Beautiful Cars. L7.4.1 Isoprofit curves and their slopes: Related to section 7.4, this note provides additional detail on isoprofit curves and their slopes using the example of Beautiful Cars. This note is particularly useful, because students may find the use of isoprofits new even if they have studied economics before. L7.5.1 The profit-maximising price: This Leibniz shows how to calculate the profit maximum related to the tangency between the isoprofit curve and demand curve using calculus. The next Leibniz shows the more usual derivation of profit maximum in economics textbooks. L7.6.1 Marginal revenue and marginal cost: This note is related to 7.6 and provides the mathematics for the alternative rationalisation of the profit maximisation condition using the MR = MC equality. The note also shows that the MR = MC characterisation of profit maximisation is formally equivalent to the first-order condition discussed in the previous Leibniz. L7.8.1 Elasticity of demand: This note is related to 7.8, and provides details on the mathematics of price elasticity of demand, an example and also the relationship between the markup and elasticity. This can be useful for discussions of the position of the price-setting curve in later units. Exercise questions Exercises in this unit provide numerical and graphical practice: Exercises 7.2 and 7.3 are about the key concepts of cost curves. 4

5 Exercise 7.5 may be a bit more challenging as it is about price discrimination, which has not been formally introduced. Unlike in many other texts, the decision to discuss a fairly common style of pricing quite early in the discussion of firm behaviour has advantages. Air ticket pricing is probably the most obvious example of price discrimination students will come up with, while at least some will mention that there are often student discounts for cinema or theatre tickets. This is a great opportunity to flesh out why the necessary conditions for price discrimination (segmented markets and different demand elasticities) are necessary. Exercises 7.6 and 7.7 are both opportunities to improve understanding of elasticity. Exercise 7.8 brings together several different strands from the unit to discuss a policy issue that is common in many contexts. Einstein It may be worth using the Einstein on elasticity in 7.8. Additional (teacher only) MCQs T7.1 tests students understanding of the isoprofit curve diagram and the optimal choice for a price setting firm. T7.2 to T7.4 test concepts of returns to scale, average/marginal cost and fixed cost. T7.5 asks students to calculate producer and consumer surplus. T7.6 asks students to use the concept of elasticity to work out changes in the equilibrium when the price increases by 10%. Looking forward Unit 7 is a particularly important unit for two reasons: Welfare analysis: Consumer and producer surplus and the idea of deadweight loss are used in later units, for example in the discussion of taxes and other government interventions. Unemployment: This is the kind of goods market that is behind the discussion of equilibrium unemployment first introduced in Unit 9, and then discussed in Unit 15 in the context of inflation and monetary policy. For a macro-centred course, it is important to teach the model in 7.5 how much of the earlier material is needed will depend on the background of the students. (Note also that the model is modified for use in Unit 22, in which the government is modelled as a monopolist setting a tax rate.) Personal teaching experience Parama I start this lecture with some examples of real life firms that students can easily recognise, for example Apple, McDonald's, and British Airways, and throw out some open-ended questions. These might include questions like: Why do cinemas/theatres often have student discounts? Why do supermarkets price match? Why are round-trip air tickets often cheaper than one-way tickets? This gets students thinking about specific pricing policies before we formally introduce price-setting. These questions also force them to reflect on the nature of differentiated products. I also use the example of bottled water to discuss product 5

6 differentiation, something that students buy themselves and can therefore relate to, but which is also the original example used by Augustin Cournot. I ask clicker questions in the lecture, focused on numerical exercises using the production function and cost curves, which help students check their understanding. I also graph the numbers in Exercise 7.3, about the cost of university education. This helps students think about the shape of different cost curves, and more importantly, refers to something they care about themselves, and can therefore relate to. Finally, I spend quite a bit of time discussing government regulation, for example. cigarette and fat taxes, using current examples, which helps cement the ideas of elasticity as well as consumer and producer surplus, and more generally, welfare analysis. Other useful resources Sin taxes The BBC reports (right) examples of sin taxes in India (fat) and the UK (tobacco). Price discrimination The Washington Post feature gives examples of the men s version of many things costing less than women s, even though there is no substantial difference in the product. o o o Menon, Supriya Why has an Indian state introduced a 'fat tax'? BBC News, 13 July. BBC Tobacco tax increase urged by parliamentary group. BBC News, 11 October. Pacquette, Danielle Why you should buy the men's version of almost everything. Washington Post Wonkblog. 22 December. 6