DEMAND CURVE AS A CONSTRAINT FOR BUSINESSES

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1 1Demand and rofit Seeking 8 Demand is important for two reasons. First, demand acts as a constraint on what business firms are able to do. In particular, the demand curve forces firms to accept lower sales if the firm wants to raise the price. Second, in a pure market system consumers affect the economy only through their demand for products. No other channel exists in a pure market system for consumers to have an effect on the economy. DEMAND CURVE AS A CONSTRAINT FOR BUSINESSES Business firms in capitalism want to earn profit. They can earn profit, however, only if they can get consumers to buy the products the firm has for sale. Capitalist firms cannot force consumers to buy their products. From this point of view, a demand curve represents a constraint for a business firm: it limits what a business firm can do. First, a firm can sell a product only if demand exists for it. Second, a firm cannot sell as much as it wants at any given price. The firm sets the price for their product and consumers determine how much they want to buy. The figure below portrays the demand curve faced by a hypothetical firm. A demand curve represents both how much consumers are willing to buy at a given price; it also represents how much a firm can sell at a given price. The figure indicates that if the firm wants to set a $20 price, they must be satisfied with selling only 100 units of their good. If the firm wants to sell more, it must lower the price. For instance, if the firm wants to sell 250 units they must set the price to $10.

2 84 Demand and rofit Maximization $20 $ THE DEMAND CURVE AND ROFITS But what price will the firm actually set: $20, $10, or something else? The answer is seemingly quite simple: the firm will set the price that brings it the most profit. In order to see how the demand curve determines what price brings the firm the most profit, it is helpful to recall how the area of a rectangle is determined. First, remember the following definition: rofit = Revenue Cost. If Cost is added to both sides we get: rofit + Cost = Revenue. Flipping the expression above around the equals sign gives: Revenue = rofit + Cost. Now, remember that Revenue is equal to rice x uantity sold or, in shorthand, x. Consider, then, the following rectangle with a base equal to and a height equal to. The area of this box, x, is equal to revenue.

3 Demand and rofit Maximization 85 rice Area of box = height x base = x = Revenue ua Since Revenue = Cost + rofit, the above rectangle must have two components: one smaller rectangle that represents cost and a second smaller rectangle that represents profit. (Remember that the area of a rectangle is equal to height times width.) Remember the definition of average cost: Average Cost = Cost/. If both sides are multiplied by, we get: Average Cost x = Cost. Flipping the two sides around the equals sign gives us: Cost = Average Cost x. Cost, then, can be represented by a box with the height of Average Cost and a base of :

4 86 Demand and rofit Maximization Average Cost Area = Cost = Average Cost x ua Because the two previous figures both have the base of uantity (and it is assumed that rice exceeds Average Cost), we can combine these two rectangles in the same diagram: rice Average Cost Cost uantity Further, since Revenue (the full area of the larger box above) = Cost + rofit, it must be that the smaller box above Cost in the figure above is equal to rofit. Finally, since rice = Markup + Average Cost we can produce the figure below:

5 Demand and rofit Maximization 87 Markup rofit rice Average Cost Cost uantity A firm desiring the most profit wants to make the profit rectangle above the biggest it can be. Bigger rectangles have bigger area; a bigger area for the profit rectangle means greater profit. For instance, in the following diagram a firm would like to make the profit rectangle (outlined with the larger dashes) as large as it can. The can be accomplished by having the largest markup (and so the largest price) and the largest uantity sold as is possible.

6 88 Demand and rofit Maximization Markup rofit A firm seeks to make this profit rectangle the biggest it can. rice Average Cost Cost uantity Unfortunately for the firm, it cannot pick whatever price and quantity sold that it would like. Consumers demand acts as a constraint on the price and quantity sold by the firm. More precisely, the market demand curve restricts possible combinations of and : while the firm can select whatever it wants, consumers decide how much the firm will sell. Consider a firm that sets the price for its good at $20. The following demand curve illustrates this situation. At this $20 price the firm sells 100 units.

7 Demand and rofit Maximization 89 rice = $ As the firm earns $20 each time it sells a unit of output, the revenue for the firm will be x, or $20 times 100. This equals $2,000. This total is equal to the area of a rectangle that is $20 tall and 100 units wide. The figure below identifies this area. $20 tall area = $20 x 100 = $2, wide

8 90 Demand and rofit Maximization The area of this box, equal to $2,000, represents the revenue earned by the firm. The firm, however, is more interested in profit. To determine the profit we need to subtract the costs paid by the firm from this revenue. Suppose that the average cost for the firm is $11 per unit. I will assume this is the average cost no matter how much the firm produces. Although in the real world average cost might vary according to how much a firm produces, not much of theoretical or practical value is lost by assuming the average cost will be $11 at all levels of output. I will presume that the firm produces exactly the amount that they sell. 1 I will, then, represent both quantity sold and quantity produced by. Because it is true that Cost = Average Cost x, then Cost can be represented by a rectangle that is AC high and wide. The area of this rectangle will equal Cost. The following figure shows such a rectangle. The rectangle is $11 high and 100 units wide. The area of this rectangle is $1,100, which is equal to the cost for the firm when it produces 100 units. $11 tall area = $11 x 100 = $1, wide 1 In the real world, of course, sometimes firms produce too much or fail to produce enough. Or, in the case of a retail store, sometimes a store orders more then they can sell or they run out of some item because they underestimated demand.

9 Demand and rofit Maximization 91 The figure below combines the figure that showed Revenue with the figure that showed cost. The next diagram is based on the fact that rofit = Revenue Cost. $9 $20 $ The large rectangle (with dimensions $20 x 100) can be broken down into two smaller rectangles: one that is $11 x 100 and a second that is $9 x 100. The lower rectangle has an area equal to Cost. As the large rectangle (with area of $2,000) is equal to revenue, the second of the smaller rectangles must be equal to profit. This is simply because rofit = Revenue Cost. The following diagram indicates both profit and cost for the firm when the price is set equal to $20. The summation of profit and cost equals total revenue, $2,000.

10 92 Demand and rofit Maximization $9 rofit = area = $9 x 100 = $900 $20 $11 Cost = area = $11 x 100 = $1, Remember that the price can be broken down into two components: rice = Markup + Average Cost This indicates that the previous diagram can be redrawn as follows. Markup rofit = area = MU x rice Average Cost Cost = area = AC x

11 Demand and rofit Maximization 93 This pair of rectangles is exactly what we had drawn before when we considered the revenue, profit, and cost for the firm unconstrained by the demand curve. But now we see that the firm is not able to select any and that it likes: rice and uantity are constrained by the demand curve. Only pairs of and found on the demand are possible for the firm to select. SEEKING HIGHEST ROFIT BY SELECTING THE MARKU Remember that the firm s goal is to maximize the area of the upper rectangle. In this effort they take as given the demand curve that the firm faces. 2 The area represents the product Markup x, which is profit. If the firm has no immediate control over the average cost, it then selects the markup to give it the highest profit it can earn, given the demand curve it faces. Consider, now, the following two figures. The first was presented above and shows that the firm has selected a $20 price and a level of sales equal to 100. The profit is $9 x 100, or $900. $9 rofit = area = $9 x 100 = $900 $20 $11 Cost = area = $11 x 100 = $1, The second diagram indicates that the firm has set a price equal to $17. At this new price the average cost remains at $11. However, the lower price was 2 This ignores the possibility that the firm carries out an advertising campaign with the goal of shifting the demand curve to the right.

12 94 Demand and rofit Maximization achieved by having a lower markup: $6 instead of the previous $9. The lower markup, leading to a lower price, permits the firm to sell more of its output than before. $17 $6 $11 rofit = area = $6 x 160 = $960 Cost = area = $11 x 160 = $1, The lower markup means the firm will make less profit every time it sells a unit of output. However, the lower markup, by leading to a lower price, permits the firm to sell more of its product. In the particular situation illustrated in the figure, the firm benefits from setting a lower markup. The increase in sales more than compensates the firm for the lower markup: the profit the firm earns rises from $900 (which it earned with a $20 price) to $960. The firm s attempt to maximize profit requires that it balance the size of the markup with the level of sales it can achieve with this markup. Now consider the following situation: the firm now lowers the markup further to $4. With this markup the price falls to $15 and sales grow to 200.

13 Demand and rofit Maximization 95 $15 $4 $11 rofit = area = $4 x 200 = $800 Cost = area = $11 x 200 = $2, This lower markup, however, fails to increase the profits earned by the firm. The lower markup does not increase sales enough to boost profits. rofits fall to $800. In this case, the firm had lowered to markup too much. The firm above will prefer the $17 price over the other two prices considered ($20 and $15) because this $17 price gives the firm the highest profit. The price, then, chosen by the firm will be $17. But it is possible that a slightly different price (perhaps $16 or $17.99) might provide the firm with an even bigger profit. With access to the demand curve it faces a firm could find that particular price that gave it the highest profit possible. Once it finds this price, the firm would use it for the goods it sells in the market. In principle, once the firm gains knowledge of the demand curve it faces it will be able to determine the price that will give it the highest possible profit, given the average cost for the firm and the demand curve it faces. THE ROLE OF IMERFECT INFORMATION A FIRM S RICE-SETTING BEHAVIOR Among the simplifications introduced in the above discussion about firm pricesetting was that firms can get accurate information about the demand curve that they face. With this information they can systematically seek price that gives them the highest profit possible.

14 96 Demand and rofit Maximization In the real world, however, a firm does not necessarily have accurate information about the demand curve that it faces. A firm might have some general knowledge about this demand curve but it rarely if ever knows the exact location of the demand curve(s) it faces. Imperfect information is a general term used to denote the fact that an economic decision-maker does not have all the information he/she needs to make the best decision. Sometimes the decision maker completely lacks some key bit of information relevant to some decision. At other times the decisionmaker has information relevant to some decision, but the information is flawed, imperfect, and perhaps wrong or misleading. Sometimes the information a decision-maker needs exists, but it requires time and/or money to get this information. Information can be costly to gather and produce. Sometimes an economic decision-maker might eventually get all the information he/she needs to make the best decision; at other times the decision-maker might find it is impossible or too costly to get all the required information. In the later case, the decision-maker must make the best decision he/she can with the imperfect information he/she has at their disposal. Consider, for instance, a firm seeking to set the price that gives them the highest profit. If the firm does not have accurate information about the location of the demand curve they face, it might expend time and money to research the demand curve. They are likely, however, to never gather perfectly accurate information about the demand curve they face. Alternatively, the firm could follow a process of trail-and-error to find what might be the highest profit they could earn. The firm could charge some initial price for its good and then see what profit they earn. The firm could then change the price up or down to find if profits rise or fall with the new price. Eventually, the firm might find some price that appears to give it the highest profit possible. This process of setting prices through trial-and-error might take some time and until the firm finally finds the profit-maximizing price the firm will earn less than maximum profit. The firm s consumers might be displeased by the continually changing price; the firm must take this into account as they try to identify the profit maximizing price. In situations of imperfect information, a firm might not carry out its pricing experiments to a final conclusion. At one point the firm might earn a profit that the firm presumes is about as high as it will get. The firm knows some other

15 Demand and rofit Maximization 97 price might give it slightly more profit but the firm doesn t think the time and expense of seeking a still higher profit is worth it. Firms, then, sometimes don t continually seek the profit-maximizing price; rather, they seek a profit that is good enough. This process of finding a good enough outcome is known as satisficing. It can be reasonable to be satisfied with a good enough profit rate in that the attempt to boost profits will more might actually cost more money than it is worth (once the cost of finding the best price is taken into account). For instance, a firm might believe that they might be able to boost its profit by $1,000 more dollars if it finds a better price; but the firm also anticipates that it will have to spend $1,300 more to find this better price. A reasonable firm, then, will stop searching for the profit-maximizing price in this situation. ROFIT-SEEKING FIRMS AND CONSUMERS Imperfect information enters into firms profit-seeking behavior in additional ways. For instance, consumers often lack full information about products they are considering buying. They might not know how well the product is made, how well the product works, or whether they will actually like the product after they purchase it. This information imperfection can lead consumers to be wary when it comes time to actually buy the product. Some might decide not to buy it because they are worried that they might be disappointed. A firm seeking to earn a high profit sometimes tries to address these concerns by consumers by offering warrantees, generous returns policies, and/or money-back guarantees. These things can help a consumer decide to take the plunge and buy the product even though the consumer realizes that he/she faces imperfect information about the product. Imperfect information can shape the buying behavior of consumers in other ways. For instance, a firm would earn more profit if the demand curve it faced was further to the right than it currently was. Such a rightward movement in the market demand curve might be accomplished if consumers believed that the product was better than it actually was. Why might consumers systematically think a product was better than it in fact was? Consider the fact that firms often have better information about the product they sell then do consumers. This situation is known as asymmetric information : one party has more, and better, information then does a second party. In such a situation the first party might find it boosts their profit to convince the second party that the product in question is better than the first party knows is in fact the case. Firms could take advantage of asymmetric

16 98 Demand and rofit Maximization information by mischaracterizing the product they sell so that consumers think it is better than it actually is. After the consumer buys the product, he/she might eventually discover that it fails to live up to the claims of the seller. Some might attempt to return the product, but others might just write off their bad experience with the product and decide the effort to try to return the product is not work the effort. The risk of opportunistic taking advantage of asymmetric information is highest when it takes consumers a long time to discover the true quality of the product and/or when the costs to return the product are relatively high. roducts sold through the mail via infomercials are often sold by opportunistic taking advantage of asymmetric information about the product quality. SUMMARY A quick look into a store, say a grocery store, reveals thousands of products with thousands of separate prices. Red Delicious apples might be priced at 89 per pound, skinless chicken breasts might be priced at $4.50 per pound, and frozen peas might be priced at $1.99. This chapter has argued that these prices are not set randomly. Two distinct factors lay behind these prices seen in the marketplace. First, a firm seeks to earn the highest profit it can. The prices we seen in the marketplace are those that firms believes will earn them the highest profit. Firms systematically seek out profit-maximizing prices and use these prices as their own. Second, consumers demand represents a constraint on firms attempts to earn the most profit they can. To find this profit-maximizing price a firm must take into account the interest that consumers have in the product. A firm s goal is to find that point along the demand curve it faces that gives it the most profitable combination of price and sales. rofit-seeking by firms and consumers demand jointly determine the prices we see in the marketplace. Often, however, the seller does not have accurate information about the demand curve that he/she faces. This complicates matters for a firm, and it often requires that a trail-and-error process be followed to find the best price for the firm. It also might lead the firm, due to the cost of information, be satisfied with a high enough profit (versus the absolutely highest profit possible). But the basic story is the same: the prices we see in the marketplace are not random but reflect sellers attempts to earn the highest profit they can faced with the set of consumers choosing that to buy in the marketplace.

17 Demand and rofit Maximization 99 One final point: in this chapter we simply assumed the firm faced a given, unchanging, demand curve. This is not so in the real world, however. Real world firms face demand curves that frequently change and move. One of the most important causes of change and movement in a demand curve is the competitive actions of rival firms in the industry. We will turn to the effect that competition has on a firm s demand curve in a later chapter.

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