Economics 103

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Economics 103

• Lecture 15
• Price Searching

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Here we are going to make another minor
adjustment to our model.
Rather than assume firms face a perfectly elastic
(flat) demand curve, now we assume firms face a
downward sloping demand.
Why might that be?
a. People are often ignorant of many things
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b. A firm may have a great location.
c. Your product might be slightly different from
the competition.
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d. Sellers might act strategically
Well leave this one until next chapter.
e. The firm might be a monopolist.
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The KEY to understanding a price searching firm,
is to understand the marginal revenue curve.
Clearly marginal revenue is falling
Recall when a firm was a price taker the
marginal revenue curve equaled the price.
Now marginal revenue is less than the price.
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For those of you who have had some calculus.
Suppose the demand curve is given by the
formula p a b Q.
If we multiply both sides by Q we get
PQ aQ bQ2
Note the left hand side is the Total Revenue.
Now take the derivative with respect to Q.
MR a 2bQ.
So the marginal revenue curve falls twice as
fast as the demand curve.
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Graphically we have
When MR0, then TR is maximized, and the
elasticity of demand is equal to 1.
MR is negative in the inelastic region of the
demand curve.
This is the only adjustment we make for price
searching.
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If the firm has ordinary cost curves, what price
would the firm set?
Notice the firm uses the same idiots rule of
thumb
This leads to a lower level of output, and a
higher price than the price taking model.
NB The price searching firm DOES NOT maximize
total revenue.
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Bono gets paid based on royalties, which are a
share of the total revenues.
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A revenue maximizer wants to lower the price
and raise the quantity to P and Q.
P
Notice Bono never has said he wants to give
his albums away.
Q
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The same disputes arises between authors and
publishers. In fact, between anyone who is paid
a royalty vs. someone who has to bear the full
costs.
How much profit is this firm earning?
We need to know the average costs.
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Suppose the average costs looked like this
Is this firm making a profit or loss?
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It would be making a profit equal to the
shaded area.
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What if the average costs looked like this
Is the firm making a profit or loss, and by
how much?
The loss would equal the green area.
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If the price searching firm was making zero
profits, then the average costs would look
This would have to be the equilibrium.
If the price searcher was earning a profit, the
price of the factor making it a price
searcher would have to rise.
The opposite would happen if the firm was making
a loss.
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Natural Monopoly.
For us this is a minor digression.
What if a firm, had declining costs over the
range of the demand curve?
Why would costs look like this?
How many firms could survive?
If you forced the firm to set PMC, what would
the profit be?