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Figure 6-3

from q to qa for the demand situation shown by the curve DDa, but an
increase only of from q to qb for the demand situation shown by DDh.
DDa is more elastic than DDb. The concept of elasticity refers both to
demand curves of individuals and of markets. The demand curve of one
individual for sugar may be more or less elastic than his own demand
curve for meat; it may be more or less elastic than his neighbor's demand
for sugar.
MEASURES OF ELASTICITY
In order to rank different demand situations in order of their elastici-
ties, the elasticity concept must be defined with more precision than we
have thus far attempted. Specifically, we must spell out what is meant
by the statement that a given change in price "exerts a more powerful
influence on quantity purchased" in one situation than in another. The
diagram used in the previous section suggests that one curve is more elastic
than another, if its slope is less steep than that of the other. In this case
we found a given fall in price resulted in a larger quantity being bought
where the curve fell less steeply.
This, however, is unambiguously true only in the special case of that
diagram where both curves referred to the same quantity axes, and the
MARKET DEMAND 91


initial position was common to both curves. In general, slope is a mis-
leading indicator of relative elasticity. Where the elasticities of demand
for two commodities are being compared, there is no obvious equivalence
in their units of quantity that should make it possible to compare the
effects of given price changes. A drop in price of say $10, increases the
demand for suits by 2 per year and increases the demand for steel by 5
tons. How does one compare 5 tons with 2 suits? Moreover, the slope
of any demand curve depends entirely on the scale used for both quantity
and price.
The standard measure of elasticity makes the concept independent of
the size of the units the quantities or the prices happen to be expressed in.
Elasticity is measured by the proportional change in quantity purchased,
that is associated with a given proportional change in price. If a 10%
drop in the price of one good is accompanied by a 50% increase in quantity
demanded, while a similar drop in the price of a second good brings about
only a 5% increase, then the first demand situation is more elastic over the
specified price range than the second.
More specifically, absolute measures of elasticity are assigned to demand
situations in the following way. A fall in price, which results in an increase
in the quantity purchased, may or may not increase the money value of
the purchases. On the one hand, a bigger quantity is being purchased;
but on the other hand, a lower price per unit is being charged. Where
the fall in price causes the quantity of purchases to increase in an amount
more than sufficient to offset the lower price per unit so that total money
value of the volume of sales increases, then the demand is said to be elastic
or to have an elasticity of more than one. Where a price fall increases
quantity demanded just sufficiently to offset the lower price per unit so
that the money value of total sales is unchanged, then the demand is said
to be of unitary elasticity or to have an elasticity of one. Where a price
fall causes quantity demanded to increase so little as to be insufficient to
maintain the original value of the volume of sales in the face of the lower
price per unit, then the demand curve is said to be inelastic or to have an
elasticity of less than one. The extreme cases are those of perfectly elastic
demand and perfectly inelastic demand.
In Figure 6-4(a), De is a perfectly elastic demand curve. No matter
whether the supply is q1 or q2, the same price can be obtained. Total
money value of sales can be increased to any desired amount without low-
ering prices even slightly; the volume of sales can be increased without
limit, even without lower prices per unit.
In Figure 6-4 (b), Dt is a perfectly inelastic demand curve. It reflects
a situation where there is no response to a price change. Lowering the
price here simply diminishes the value of total sales by reducing the
revenue per unit without in any way increasing the number of units sold.
92 MARKET THEORY AND THE PRICE SYSTEM

Price Price




A "¯*




Figure 6-4

It should be clear from this discussion that, in general, it is meaning-
less to speak about the elasticity of "a demand curve." Elasticity, as a
concept that is measurable, at least in principle, relates to a response to
a given price change. In speaking of the elasticity of a demand curve, one
must specify the particular range of prices over which the response of
quantity taken to price changes is being measured.3 This can be illus-
trated by means of Figure 6-5.

Price




Figure 6-5
3 The term "elasticity of demand" is frequently reserved for the elasticity concept as
measured over an infinitesimally small portion of the demand curve. Where p, q, re-
spectively represent the price and quantity at a point on the demand curve, and ¿±p,
¿±q represent infinitesimally small changes in price or in quantity, the elasticity of de-
mand at that point is calculated as ¿±q/q ¯¯ AP/P· (It: w i l 1 b e observed that for a
·
downward-sloping demand curve this formula will result in a negative number, since
¿±q and ¿±p are of opposite sign to one another.) Where the range over which demand
elasticity is to be measured is of finite size, the point elasticity formula will yield various
values depending on the particular values of p, q, inserted in the formula. A number
of "arc elasticity" formulas have been devised to yield unique elasticity values for such
cases. (For further discussion of this point see e.g. Weintraub, S., Price Theory, Pitman
Publishing Corp., New York, 1949, pp. 46-48.)
MARKET DEMAND 93

In the diagram AB is a straight line representing a demand curve.
With any point R on the demand curve, is associated the amount of sales
revenue it yields. This sales revenue is, of course, the product (pq) of
(a) the price per unit (p), and (b) the number of units sold at that price
(q). The elasticity of the demand curve in the region of any such point
R depends, we have seen, on whether the value of pq rises with a fall in
price (elastic demand) or falls (inelastic). With a straight line demand
curve such as AB, starting at A and going down to B, the value of p—q
rises from zero, reaches a maximum, and declines once again, at B to zero.
It is clearly impossible to call the demand either elastic or inelastic. At
high prices demand is elastic (lowering the prices increases total revenue);
in the neighborhood of the price at which revenue is a maximum, elasticity
is approximately unitary (because a fairly small price change in that neigh-
borhood leaves total revenue about the same); while at the lower prices
(where a further fall in price would reduce total revenue) demand is dis-
tinctly inelastic.
Elasticity measures apply, of course, both to individual and market
demand. In all cases an inelastic demand over a given price range means
that individuals are only slightly responsive to the price changes. Only
a significant price fall is sufficient to attract any increase in the quantity
that market participants will buy; only a significant price rise is sufficient
to force a cutback in quantity purchased. In marginal utility terms, an
individual whose demand for a good is inelastic ranks a unit of the good
on his value scale very much higher than those units of other goods that
are lower on the scale; and, on the other hand, he ranks the unit of this
good very much lower than those units of other goods that are higher on
the scale. Evidence of this is the fact that a moderate change in price
is unable to alter the relative position on the value scale, with respect to
fixed quantities of other goods, occupied by a "dollar's-worth" of this good
”even though the size of a "dollar's-worth" is now larger or smaller than
before the price change.
On the other hand, an individual whose demand for a good is elastic
ranks a unit of this good with respect to given sized units of other goods
in such a way that even a small change in relative price makes it attractive
for him to shift expenditure at the margin between this good and the
other alternatives available. In the market as a whole the elasticities of
demand curves manifest themselves, as we have seen, in the change in the
amount of total sales revenue which is expected to follow a fall or rise in
price.
94 MARKET THEORY AND THE PRICE SYSTEM



MARKET DEMAND AS SEEN
BY THE INDIVIDUAL ENTREPRENEUR
Thus far we have discussed market demand as a whole. We have
seen that this concept focuses on the quantities the market will ask at
different market prices. These quantities, we found, reflect the quantities
that the individual market participants separately ask at these prices. We
must now put ourselves in the position of the individual firm producing
goods for sale and ask how market demand appears from this position.
The perspective on market demand, which we have already gained, to-
gether with that on market demand as seen by the firm, which we now
consider, will enable us at a subsequent stage to understand how the inter-
locking chains of decisions of buyers and producers determine market prices
and the output of both individual firms and entire industries.
To the individual entrepreneur operating a firm in an industry, the
relevance of market demand does not hinge directly on the relation be-
tween market price and the quantity that the market as a whole will seek
to buy. For him market demand is relevant only as it relates to the quanti-
ties that the market will buy of his product, and to the prices that he may
charge, other factors remaining unchanged. He is interested, in other
words, in the different alternatives the market as a whole might present
to him as a result of alterations by him in the alternatives that he presents
to the market.
It is clear that the alternatives the market as a whole presents to any
one entrepreneur, in response to a given price posted by him, depend on
a number of factors besides the shape of the market demand curve, or its
elasticity in the neighborhood of this price. The quantities of a com-
modity that the market will seek to buy altogether at a given market price
depend, we have seen, on a number of factors, including the prices and
availability of other goods. The quantities of a good the market seeks
to buy from any one entrepreneur, at a given price charged by him, will
depend, in addition to all the factors that we found operative upon market
demand”upon the prices and availability elsewhere of the same good.
This plays an important role in explaining the different ways prices and
output are determined in monopolized and competitive markets.
If we place ourselves in the position of a firm that monopolizes the
particular commodity, then the relevant demand curve is identical with the
demand curve of the market as a whole. In such a situation the only
alternatives (with respect, it must be emphasized, to purchase of the mo-
nopolized product) available to market participants are those offered by
the monopolist. The only competition he faces is that of other goods and
services; thus, the quantities of this good that the market will seek to buy
from the monopolist are identical, for each price, with the quantities that
MARKET DEMAND 95


the market as a whole would seek to buy altogether, at the same market
prices, from a market of competing producers.
The elasticity of the demand curve facing a monopolist, over any
price range, is thus the same as that of the market demand curve. The
decisions of the monopolist concerning what price to ask will therefore
hinge, partly, on his estimation of the elasticity of demand of the market,
since it is this factor that reflects the alternative amounts of revenue the
market permits him to choose from.
The situation is quite different when viewed by an entrepreneur whose
product is made available to the market by other producers as well. The
competitive entrepreneur realizes that there is a going market price at
which the market can buy elsewhere. If he himself asks a higher price
than that asked elsewhere in the market, it is plain that everybody will go
elsewhere when the same good is available more cheaply. On the other
hand, it is equally plain to the competitive entrepreneur that even a
moderate reduction of his price below that asked elsewhere in the market
will attract a large number of buyers to him. In other words, if he offers
the market alternatives less favorable to consumers than those offered
by his competitors, the quantity of his products the market will ask for
will be very slight; if he offers alternatives more attractive to the consumers
than those offered elsewhere, the quantity asked of his product will be
very large. The elasticity of the demand of the market for his output is
thus very high”much higher than that of the market demand curve as a
whole. The individual entrepreneur in a competitive market knows that
the consumers will be highly responsive to any price change on his part.
Whether or not the elasticity of demand faced by a competitive firm
will be infinitely high (that is, whether the demand curve facing it will be
a horizontal straight line) depends largely on the degree of similarity be-
tween the products offered by the competing firms. If these products are
exactly the same in all respects, from the point of view of consumers, then
indeed any one entrepreneur will find that a very small reduction in price
(from slightly above the market price to slightly below the market price)
will increase his sales revenue from zero to very large amounts indeed.
If the similarity between the products, as seen by the consumers, is
not quite perfect, however, then the elasticity of demand faced by any one
competing firm, while probably very high, will be something less than in-
finite. Thus, a slight reduction by one corner drugstore on the retail
prices charged for a branded commodity, say toothpaste, will not attract
all the customers for toothpaste away from other drugstores that have not
made the price cut. This is because "toothpaste available at one drug-
store" may not be perfectly similar to "toothpaste available at another
drugstore," from the consumers' point of view. The physical identity of
the branded merchandise is not necessarily the relevant criterion here; to
96 MARKET THEORY AND THE PRICE SYSTEM

some consumers one drugstore may be a few steps further away than an-
other, one drugstore may be more pleasant to do business in than another,
and so on. Where there is some (real or imagined) physical difference be-
tween two closely similar products, such as two different kinds of tooth-
paste, or an identical toothpaste marketed under two different brand names,
then of course we can similarly expect the demand curve facing any one
seller to be highly, but still less than infinitely, elastic.
These considerations need to be borne in mind when we come to
analyze the market forces determining prices in various types of markets.

DEMAND AND REVENUE
Our discussion of the demand curve and its elasticity faced by the firm
suffices to make clear the relationship between demand and revenue. The
entrepreneur is interested in knowing all the alternatives open to him.
Among the key alternatives concerning which he desires information are
the various amounts of sales revenue that may be expected to be forthcom-
ing under specific circumstances of price and output. Here the demand
curve facing the firm plays the decisive role.
Let us suppose that a firm believes itself to be confronted with a de-
mand curve DDX. This means that he can sell a particular quantity, OB,

Price




of the good at a price OA per unit. There are a number of revenue con-
cepts implicit in this price-quantity relationship, and the entrepreneur may
be interested in each of them for particular purposes. The most obvious
revenue concept is that of total revenue. If he is able to sell the quantity
OB at a price of $OA per unit, then he receives the quantity OB—OA dol-
lars in total sales revenue. This figure is clearly important to the entre-
preneur, because by subtracting the total costs of its production from the
MARKET DEMAND 97


total revenue of a given quantity of output, he can immediately calculate
the profit associated with a given level of output. In graphic terms, the
total revenue for any output OB is represented by the area of the rectangle
OBRA (that is, quantity, OB, multiplied by price, OA).
A second and related concept is that of average revenue per unit of
output. Since the total revenue from the sale of the quantity OB is OBX
OA, it follows that the revenue per unit is OB—OA; that is, $OA per
OB
unit. OA was the price each unit of the quantity OB can be sold at and
is thus, of course, the average revenue for this number of units received by
the entrepreneur. It is noted that as the quantity of output increases (in
the situation shown in Figure 6-6), the revenue obtained per unit of output
declines. Larger quantities of output can only be sold by the firm at pro-
gressively lower prices since the demand curve facing it slopes downward
to the right. It can be seen, in fact, that the curve of demand facing the
firm is identical with a curve relating the firm's average revenue from out-
put to the size of the output. Any point on the demand curve facing the
firm, showing the quantity that the market will buy of the firm's products at
a given price, shows at the same time the price per unit this quantity of
output can be sold at”which, from the point of view of the firm's books,
means the revenue, per unit of output, obtained from this level of output.
The coincidence of the demand curve facing a firm, with the firm's curve
of average revenue for output, holds true, in this way, regardless of the
slope of the demand curve. If a firm is in a highly competitive market so
that the elasticity of the demand it faces is very high, then it will find that
it is able to expand output with hardly any drop in the revenue obtained
per unit. The average revenue curve in this case, like the demand curve,
is very nearly a horizontal straight line.
Another related concept is marginal revenue. Marginal revenue is
the amount of revenue at stake in any decision whether or not to produce
a given marginal unit. Suppose a firm could obtain $1,000 total revenue
by producing and selling 100 units of a commodity, and an increase of out-
put by 1 unit would raise total revenue to $1,005; the marginal revenue of
a 101st unit would be $5. The addition to output and sales of a 101st
unit means an additional $5 in total revenue. Any decision as to expan-
sion or contraction of output by any given number of units must hinge
partly on the difference to total revenue made by the number of units under
consideration.4
4 The reader will observe the parallel between the notion of marginal utility (dealt
with in the preceding chapter) and that of marginal revenue treated here. Both no-
tions (like other marginal concepts we will be dealing with) focus attention on the
difference that a proposed additional unit of something (such as "quantity sold") makes
in some calculation (such as an estimate of revenue) made by an interested individual.
98 MARKET THEORY AND THE PRICE SYSTEM

It is worthwhile to notice some straightforward arithmetical relation-
ships between total, average, and marginal revenue.5 (1) The average rev-
enue of any output, as we have seen, is simply the total revenue obtained
from that output divided by the number of units of the output. (2) The
marginal revenue of any marginal unit, we saw, is the difference between
the total revenue of output including this unit and the total revenue of
output excluding this unit. The marginal revenue of the 101st unit is
thus the difference between the total revenue from 101 units and the rev-
enue from 100 units. (3) It follows directly that the total revenue of, say,
101 units is equal to the sum of the marginal revenues of the 1st, 2nd, 3rd,
. . . and 101st units (since the marginal revenue of each unit of output is
the amount added on to total revenue by the decision to step up output
to include this unit).6 (4) If revenue per unit of output (average revenue)
were the same for all levels of output, this must mean that the marginal
revenue of any one unit is the same as that of any other unit, and that the
value of this marginal revenue is the same as the average revenue. If a firm
can sell any amount it pleases at a constant price, then this price is by
definition both average revenue and marginal revenue. Thus, where a firm
faces a perfectly elastic (horizontal) demand curve, this curve, beside being
coincident with the average revenue curve, coincides also with the marginal
revenue curve. (5) Where average revenue falls with increasing output,
then marginal revenue must be less than average revenue. If the additional
revenue obtained by adding a marginal unit to a given level of output were
more than the revenue per unit of this level of output, then the revenue per
unit of the expanded level of output would be increased. If marginal
revenue were the same as the previous revenue per unit, then the revenue
per unit would not change with the expanded output. Falling average
revenue thus signifies a marginal revenue less than the average. It is pos-
sible for average revenue to fall so low that marginal revenue is negative.
Such a situation exists when increased output can be sold only at so low
a price that total revenue declines with the expanded output.
The marginal revenue of any particular unit of output thus clearly
depends on the slope of the demand curve facing the firm at this level of
output”that is on the elasticity of the demand curve in the neighborhood of
this output.7 For a demand curve of less than perfect elasticity, increased

An important respect in which marginal revenue differs from (ordinal) marginal utility
is that the former notion (unlike the latter) refers to a cardinal number (a specific sum
of money).
5 Analogous relationships exist between the total, average, and marginal values for all
cardinal magnitudes (such as cost, output, and so on).
6 Graphically, therefore, the area below the marginal revenue curve up to a given sales
quantity may represent the total revenue for that quantity.
7 Mathematically the relationship between price (p), marginal revenue (MR), and
elasticity of demand (e) is represented by the formula MR = p + p/e· For a down-
MARKET DEMAND 99


output requires a lower price. Whether this increase in output raises total
revenue, lowers it, or leaves it unchanged, depends, we found, on demand
elasticity over the relevant range. With elastic demand, total revenue
increased; with inelastic demand, total revenue declined; with unitary elas-
ticity, total revenue remained unchanged. Therefore, with a downward-
sloping demand curve, we can generalize by saying that (a) positive marginal
revenue (that is, rising total revenue) is associated with elastic demand;
(b) negative marginal revenue (that is, falling total revenue) is associated
with inelastic demand, and (c) zero marginal revenue (that is, total revenue
unchanged with increased output) is associated with demand of unitary
elasticity.8

DEMAND AND THE PRICES OF OTHER GOODS
Throughout the discussions of individual and market demand, it has
been emphasized that the quantity of any one commodity that will be asked
for in the market at any given price depends in large part on the prices and
availability of other goods and services. The number of air reservations to
Florida beach resorts at a given price depends in part on the price of train
tickets over the same distance, on the availability and price tag of alterna-
tive resorts, and may even depend partly on the prices of quite different
kinds of goods. Each consumer, we found, allocates his income among an
immense variety of goods according to their relative marginal utilities.
The amount of income he will seek to spend on any one good depends not
only on the marginal utility of a "dollar's worth" of this good, but also on
the marginal utility of a dollar's worth of all other goods. This dependency
on the prices of other goods is aggregated in the market so the quantity of
any one commodity that the market as a whole seeks to buy at a given price
depends heavily on the particular pattern of prices prevailing for other
goods. The concept of cross elasticity is of some importance in this con-
nection.
Cross elasticity gauges the degree of sensitivity of demand for one
product to price changes in a different product. Supposing there is a
50% rise in the price of college tuition; what can be said about the quantity
of college textbooks that will be bought at a given price? Very likely there
will be a decline. On the other hand, what is likely to happen to the de-

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