1. 7-1 Economics: Theory Through Applications

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3. 7-3 Chapter 7 Where Do Prices Come From?

4. 7-4 Learning Objectives What is the goal of a firm? What is the demand curve faced by a firm? What is the elasticity of demand? How is it calculated? What is marginal revenue? What is marginal cost? What costs matter for a firm’s pricing decision?

5. Learning Objectives What is the optimal price for a firm? What is markup? What is the relationship between the elasticity of demand and markup? What is a perfectly competitive market? In a perfectly competitive market, what does the demand curve faced by a firm look like? What happens to the pricing decision of a firm in a perfectly competitive market? 7-5

6. The Goal of a Firm 7-6

7. Figure 7.1 - A Spreadsheet That Would Make Pricing Decisions Easy 7-7

8. Figure 7.2 - A Change in Price Leads to a Change in Profits 7-8

9. Figure 7.3 - The Profits of a Firm 7-9

10. The Goal of a Firm 7-10

11. The Revenues of a Firm 7-11

12. Figure 7.4 - A Change in the Price Leads to a Change in Demand 7-12

13. The Demand Curve Facing a Firm 7-13

14. Table 7.1 - Example of the Demand Curve Faced by a Firm 7-14

15. The Demand Curve Facing a Firm 7-15

16. Figure 7.5 - Two Views of the Demand Curve 7-16

17. The Elasticity of Demand: How Price Sensitive Are Consumers? 7-17

18. Figure 7.6 - The Elasticity of Demand 7-18

19. The Elasticity of Demand: How Price Sensitive Are Consumers? 7-19

20. Figure 7.7 - The Elasticity of Demand When the Demand Curve Is Linear 7-20

21. Figure 7.8 - Finding the Demand Curve 7-21

22. Measuring the Elasticity of Demand 7-22

23. Figure 7.9 - Revenues 7-23

24. Table 7.2 - Calculating Revenues 7-24

25. Figure 7.10 - Revenues Gained and Lost 7-25

26. Figure 7.11 - Calculating the Change in Revenues 7-26

27. Marginal Revenue 7-27

28. Marginal Revenue and the Elasticity of Demand 7-28

29. Figure 7.12 - Marginal Revenue and Demand 7-29

30. Marginal Revenue and the Elasticity of Demand 7-30

31. Figure 7.13 - Marginal Revenue and the Elasticity of Demand 7-31

32. Table 7.3 7-32

33. Marginal Cost 7-33

34. Figure 7.14 - Marginal Cost 7-34

35. Table 7.4 - Marginal Cost 7-35

36. Figure 7.15 - An Example of a Cost Function 7-36

37. Figure 7.16 - Changes in Revenues and Costs Lead to Changes in Profits 7-37

38. Figure 7.17 - Setting the Price or Setting the Quantity 7-38

39. Figure 7.18 - Optimal Pricing 7-39

40. Markup Pricing: Combining Marginal Revenue and Marginal Cost 7-40

41. The Markup Pricing Formula 7-41

42. Figure 7.19 – A Price Algorithm 7-42

43. Figure 7.20 - The Demand Curve Facing a Firm in a Perfectly Competitive Market 7-43

44. Perfectly Competitive Markets 7-44

45. Table 7.5 - Costs of Production: Increasing Marginal Cost 7-45

46. Figure 7.21 - The Supply Curve of an Individual Firm 7-46

47. Key Terms Profits: Revenues minus costs Revenues: What a firm receives for selling its output, which is equal to the price received per unit sold times the number of units sold Costs: The payments a firm makes for its inputs, such as wages for its workers Choke price: The price above which no units of the good will be sold Own-price elasticity of demand: The percentage change in quantity demanded of a good divided by the percentage change in the price of that good 7-47

48. Key Terms Market power: The extent to which a firm produces a product that consumers want very much and for which few substitutes are available Marginal revenue: The extra revenue from selling an additional unit of output, which is equal to the change in revenue divided by the change in sales Marginal cost: The extra cost of producing an additional unit of output, which is equal to the change in cost divided by the change in quantity 7-48

49. Key Terms Markup: The price over marginal cost, which is equal to (1 + markup) × marginal cost Individual supply curve: How much output a firm in a perfectly competitive market will supply at any given price – It is the same as a firm’s marginal cost curve

50. Key Takeaways The objective of a firm is to maximize its profit, defined as revenues minus costs The demand curve tells a firm how much output it can sell at different prices The elasticity of demand is the percentage change in quantity divided by the percentage change in the price Marginal revenue is the change in total revenue from a change in the quantity sold 7-50

51. Key Takeaways Marginal cost measures the additional costs from producing an extra unit of output It is only the change in costs—marginal cost—that matter for a firm’s pricing decision At the profit-maximizing price, marginal revenue equals marginal cost Markup is the difference between price and marginal cost, as a percentage of marginal cost 7-51

52. Key Takeaways The more elastic the demand curve faced by a firm, the smaller the markup A perfectly competitive market has a large number of buyers and sellers of exactly the same good In a perfectly competitive market, an individual firm faces a demand curve with infinite elasticity In a perfectly competitive market, the firm does not set a price but chooses a level of output such that marginal cost equals the market price 7-52