basic economics
- the price of everything is the rate at which it can be exchanged for anything else
- elementary economic theory states that firms are price acceptors not price setters, and that the price for a commodity or service is a function of supply and demand
what is the economic model assumption?
an organisation will attempt to set its prices at a level where profits are maximised
monopoly
(imperfect competition)
the lower the price the higher the volume of sales
factors to be aware of
- organisation’s objectives
- market within which organisation operates
- demand
- supply
- PED
- costs
- competition
- inflation
- legislation
- availability of substitutes
demand is influenced by
- price of the good
- price of other goods
- size and distribution of household income
- tastes and fashion
- expectations
- obsolescence
for most products and services quantity demanded falls as price increases
how does economic theory depict organisational decision-making?
neo-classical economics suggests that decision-makers will take decisions which tend to move the firm towards profit-maximising behaviour
- this will occur at “The Equilibrium of the Firm”
what is the Equilibrium of the Firm?
the selling price and volume (quantity) combination which maximises the differences between total revenue and total costs
profit maximising behaviour: “the equilibrium of the firm”
- since profit = TR - TC, then profit = (average revenue - average costs) x quantity
- this is represented by the area of rectangle ABCD in the under imperfect competition graph of profit-maximising price and quantity
- this area is maximised where MC = MR
- because if activity (quantity) expands beyond this level, costs will increase faster than revenues
- revenue is maximised where MR = 0
what assumptions do you make?
assuming that price/demand relationship is of a linear nature and that increases in demand will not change FCs
what is marginal revenue?
total earned from one extra unit of sales
what is marginal cost?
additional cost of one extra unit
what can you do knowing that profit is maximised at MC=MR?
we can:
- produce an estimate of sales demand at various prices
- calculate TR at each different price
- calculate TC at each level of sales demand
- calculate MR
- calculate MC (marginal cost)
- at the price where MR and MC are the closest = profit maximisation
how do you calculate marginal revenue and marginal cost?
- calculate total revenue i.e. sales quantity x sales price
- MR = total revenue for (n) - total revenue for (n-1, i.e. the one from before)
- average cost (given in question)
- work out total cost using average cost per unit x number of units (may be given the first value for 0 units in q)
- work out marginal cost = total cost for (n) - total cost for (n-1)
- work out profit by doing TR - TC
- can find where profit is maximised where MC = MR (or the closest to)
what is the equation of the demand curve?
P = a - bq
- where P = price
- a = price at which demand is 0
- b is the slope (gradient) of the demand curve
why is the demand curve important?
- once we have found the demand curve we can find the TR
- once we know TR we can find MR
- we can then set MR = MC to get the price and quantity for profit maximisation
deriving a demand curve
we need an estimate of the sales demand at various selling prices so we can formulate the demand function:
where: P = a - (bq / change in q)
- P = price
- Q = quantity demanded
- a = price at which demand would be 0
- b = the amount by which the price falls for each stepped change in demand
- change in q = the stepped change in demand
where:
a = current price + [(current quantity at current price / change in quantity when price is changed by b) x b]
how do you find the value of a in the demand curve?
a = current price + [(current quantity at current price / change in quantity when price is changed by b) x b]
where b = the amount by which the price falls for each stepped change in demand
how to calculate profit maximisation demand using demand curve?
- use differentiation!
- rate of change in TR will give MR (differentiate TR)
- rate of change in TC will give MC (differentiate TC)
- VC per unit is aka marginal cost per unit
- multiply demand curve by Q to get TR and then differentiate to get MR
- substitute value of MC if given (aka VC per unit)
how to recommend a unit price which would maximise profit and find the quantity demanded at that price?
- find the demand curve equation (P = a - bq)
- multiply by Q to get TR
- differentiate to get MR = MC and substitute value of MC (vc per unit to get Q)
- substitute into demand curve to work out price (P)
- if it is a decimal (e.g.64.5) would need to test contribution at 64 and 65 (= price - vc per unit)
- also work out total contribution (contribution per unit x q found in step 3)
- can also work out profit by = total contribution - FCs (given in q)
- compare which one gives you more profit or if they are the same?
