MC=MR

by Don Boudreaux on June 4, 2011

in Complexity & Emergence, Economics

A few commenters on this post wonder why I assume that, if BMW invents a method for reducing its costs of producing automobiles, it will therefore lower the prices it charges for its cars.  Won’t BMW simply enjoy lower costs on the automobiles it produces – lower costs that increase BMW’s profits – rather than dissipate these higher profits by cutting the prices of its automobiles?

No.  If BMW doesn’t expand its output, it would earn fewer profits than it would earn by lowering its prices.

More specifically, the economist’s answer (and, remember, the original question on the pop quiz is from an exam I gave to students in my Principles of Microeconomics class) is that each period each firm expands the quantity of its output up to the point at which that firm’s marginal revenue becomes equal to that firm’s marginal cost.  Only in this way do firms maximize their profits.

Marginal cost – the cost of producing an additional unit of output – rises as quantity produced rises.  (Marginal revenue – the change in the firm’s total revenue that results from selling one additional unit of output – falls as the firm sells more and more output if selling these additional units of output requires the firm to lower the prices it charges for its outputs.)

The efficiency-enhancing machine lowers BMW’s schedule of marginal costs; that is, use of the machine lowers BMW’s marginal cost at each possible quantity of output.  With a now-lower schedule of marginal costs, the (upward sloping) marginal-cost curve intersects the (generally downward sloping) marginal-revenue curve at a higher quantity of output than previously.  So it pays BMW to produce and sell more automobiles even though BMW can sell these additional automobiles only by lowering its prices.

If BMW does not lower its prices in this situation it leaves money on table (or, as economists say, it doesn’t maximize its profits).  If BMW doesn’t lower its prices in this situation it would continue to sell the same quantity of automobiles that it sold before its costs fell.  So it would produce and sell some automobiles profitably (automobiles whose production and sale add more to BMW’s revenues than they add to BMW’s costs) but not the full quantity of automobiles whose production and sale add more to BMW’s revenues than they add to its costs.

In short, because the machine lowers BMW’s costs of production, the number of automobiles that it is now profitable for BMW to produce and sell is greater than it was before BMW started using the machine.  But to sell this higher quantity of cars requires BMW to lower it prices.  And so BMW lowers the prices it charges for its cars.

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{ 62 comments }

Rick Weber June 4, 2011 at 11:26 am

There’s a second aspect to this example that is worth making explicit for principles students. MC has shifted, but MR has not. When we draw it out, it becomes very clear that BMW wants to increase output.

Don Boudreaux June 4, 2011 at 11:30 am

Yep.

Mike P.F. June 4, 2011 at 12:24 pm

“So it pays BMW to produce and sell more automobiles even though BMW can sell these additional automobiles only by lowering its prices.”

But you still assuming BMW would sell additional automobiles only by lowering prices. There is such a thing as lowering costs but not lowering prices…

LowcountryJoe June 4, 2011 at 12:37 pm

In a Principles of Microeconomics course, you would have to assume that you sell more units of what you’re producing if you were to lower the price: the whole Law of Demand rests on it.

Mike P.F. June 4, 2011 at 2:20 pm

Yes, in aa introductory microeconomics course you make that assumption. that assumption breaks down when you have a highly oligopolistic economy as the one we have. large companies are sometimes in positions where they can lower costs and do not necessarily have to lower prices.

I’m not sure why you brought up the law of demand. I didn’t say that BMW lowering prices wouldn’t necessarily lead to more sales. There are other determinants of demand…substitutes, incomes, consumer preferences, expectations…

lamp3 June 4, 2011 at 2:35 pm

In Don’s example, consumers demand for vehicles does not change because car production is more efficient. BMW’s supply curve shifts to the right because it is more efficient at producing vehicles at all price levels. So the new market clearing point moves downward to the right as well, increasing consumer and seller’s surplus.

You are right that BMW may not change the number of cars it sells. However, this would mean BMW is choosing to forgo profits.

I don’t know how an oligopoly would make this any different, because even in a two-car-brand scenario — BMW and Ford, for instance — it’d still be in BMW’s interest to make more profit.

Dan June 4, 2011 at 6:39 pm

All things equal…………

MT June 5, 2011 at 8:26 am

This cycle is continually demonstrated in technology firms (think Intel, EMC, etc.).

Don Lloyd June 4, 2011 at 12:34 pm

“… Marginal cost – the cost of producing an additional unit of output – rises as quantity produced rises…. ”

This wouldn’t seem to be universally true. Higher input quantities may be available for lower per unit prices. If an input imported from the Far East doesn’t fill the plane, then an increased quantity of inputs may lower the average input transportation cost. A factory operating at less than full capacity may be able to increase production with little or minimal increase in some costs.

Regards, Don

vikingvista June 4, 2011 at 2:27 pm

Doesn’t changing the cost of inputs violate the implicit c.p., even if it is a changing function of quantity? Changing input costs shifts the schedule, it does not move along the schedule.

Marginal costs increase, because you are making finite resources more scarce, so their use is more costly.

For example, if you are going to hand make a second widget for sale, it will take you the same amount of time as the first widget. However, you will be taking that time from a more depleted quantity of your free time. The curve is necessarily concave up. Any innovation that reduces the time to produce, or reduces other input costs, is a downward shift in the curve.

patrick June 4, 2011 at 12:40 pm

I believe a better example would include toyota and honda rather than BMW and Chevy. BMW is a luxury carmaker while chevy is a midrange car maker.

The “status” of a BMW yields a higher price. Direct substitution would occur between honda and toyota.

Stephan June 4, 2011 at 1:04 pm

This post is only bullshit. Another example of an economist divorced from reality. I’ve worked for Porsche and any Porsche manager hearing this story would put up a polite smile and think what is this guy (my polite version) talking about? Another good example why microeconomics is only a waste of time.

Tim June 4, 2011 at 4:39 pm

Then Porsche managers are idiots for leaving money on the table, choosing to earn smaller profits.

Dave June 4, 2011 at 1:30 pm

I think there’s one fatal flaw in this reasoning: it fails to take into account that during this same time period, the Fed is devaluing the currency, making the cars more expensive.

Tim June 4, 2011 at 4:43 pm

Darn, you’ve blown a fatal hole through our whole macroeconomic house of cards! If only economists had included a disclaimer that reality can diverge from theoretically predicted scenarios if other variables aren’t held equal. We could have come up with some fancy Latin phrase for it… maybe something like ceteris paribus.

Dan June 4, 2011 at 6:40 pm

All things equal……..

Dan June 4, 2011 at 6:45 pm

Or the rise in the tides, planetary alignment, Chinese currency manipulation, Russian sales of vodka, etc.,…… Didn’t take into consideration the price of platinum as sales increased and the higher demand to coat catalytic converter……. Oh, just start over…… BMW would go bankrupt if they could sell cars at a cheaper price, sell more cars, make more profit, expand their line of vehicles, etc.,…. They would never want to sell more cars……….oh, the sarcasm will never cease……

kyle8 June 4, 2011 at 1:40 pm

I absolutely understand your explanation and I understand this is a question to teach students basic economic principles. However, there is an alternative in which BMW (or any firm with or without an efficiency machine) might maximize profits. And that would be to produce a purposefully limited line of product, having a reputation of quality, and charging a very high price. This would be the idea of exclusivity.

This only bears upon the question because BMW at this time does enjoy a reputation for quality. If they lowered their prices too much then sales to at least a portion of their customer base may decline because of the suspicion that quality has decreased.

Dan June 4, 2011 at 6:49 pm

That can be answered. Did Ford profit handsomely from their limited release of T-birds? How about Chrysler and the Prowler?
If so, then I would have expected more, such as a limited release of an El Camino. But, don’t see any of this occurring. Although, overall market is weak.

SheetWise June 4, 2011 at 3:26 pm

How would you apply these principles and establish pricing if the marginal cost of producing an additional unit was zero. I’m specifically thinking of software downloads where process of selling a license is completely automated.

vikingvista June 5, 2011 at 7:26 pm

Not zero, but perhaps negligible. The flat part the curve extends to very high quantities, but ultimately computing power is finite like everything else. The curve is still asymptotic to some (high) quantity.

SheetWise June 5, 2011 at 7:50 pm

Many times the marginal cost is below zero. A couple of paid ads on the page, and you’ve more than covered bandwidth. The same is true with many paid music and video downloads.

Then there’s the free downloads, where the marginal cost of an additional unit is free but it produces advertising revenue — and you want to give it away free as fast as you can.

vikingvista June 5, 2011 at 8:31 pm

No, you’re shifting the curve to make it look like negative marginal costs.

But consider this, what would be the marginal cost of the 10^100000th download during the noon hour on Monday? You see, the quantities are still scarce, and the same scarcity rules, including increasing marginal costs, still apply. When you are only at the 100th download, the scarcity is barely affected, and the marginal costs are nearly zero. This is no different than anything else, except that you are always playing at the very low end of the curve.

SheetWise June 6, 2011 at 11:09 pm

“No, you’re shifting the curve to make it look like negative marginal costs.”

No I’m not. Yes, there is a limit — but could a BMW dealer sell 2,000,000 cars over a lunch hour? No. I could — with no cost, making a profit on every one — selling them at 29.95 … I can get bandwidth on demand, up to certain limits — but there are limits on the supplied example as well.

vikingvista June 6, 2011 at 11:30 pm

“but could a BMW dealer sell 2,000,000 cars over a lunch hour? No. I could”

The specific quantity is irrelevant. What is relevant is that there is a limit. That is what matters. As you approach that limit, the effect of scarcity and accelerating marginal costs become readily apparent. But those same affects–the reason for the necessarily skyrocketing marginal costs near the upper limit–are present for ALL quantities.

The only way to get around that, for instance to achieve negative marginal costs, is to shift the curve. The schedule is defined for a fixed set of conditions. The only things allowed to change for a given schedule are the quantities traded (e.g. dollars and widgets). If you change anything else, you are shifting the schedule. You are incorporating an effect that changes the price for a given quantity, or changes the quantity for a given price.

At the flat end, you may personally achieve zero marginal cost, because it isn’t worth charging tiny fractions of a penny. But you are using up bandwidth, and that is a cost to somebody. At some quantity, the bandwidth owner will find it worthwhile to charge more.

SheetWise June 7, 2011 at 10:39 pm

“The specific quantity is irrelevant. What is relevant is that there is a limit. That is what matters.”

I’ve already thrown out macro — this is the type of thinking that will make me throw out micro.

vikingvista June 8, 2011 at 12:05 am

“this is the type of thinking that will make me throw out micro.”

I wish I understood what you meant. Micro is easy. It makes sense. But its conceptual tools, both deductive and true, are for scenarios far simpler than anything you ever really experience in isolation. You CAN’T *simply* produce more out of increasingly limited resources without increasing marginal costs, even if negligibly. But you can incorporate other factors, like changing the schedule itself. In reality, many more complications, such as stair-step pricing by your suppliers, are occurring.

DJB June 4, 2011 at 5:08 pm

Some writers are somewhat correct in stating that prices may not drop, their error is in assuming that BMW would simply pocket the profit and for go increased sales. As price in luxury items is often a signaling tool, BMW may find a lower MSRP to be perceived by costomers as a sign of reduced quality. However, as all money’s are fungible, the saving in production may be shifter to improved design and function, broader advertising, improved costumer service, a decrease in repair parts and labor of certified BMW mechanics… The money saved will go to improving sales and force other companies to become more competitive, either way the consumer wins.

John Dewey June 6, 2011 at 9:22 am

Agree with your thiniking, DJB.

BonnieBlueFlag June 4, 2011 at 6:01 pm

This is elementary. Readers need to focus less on political economy and more on basics. Without an understanding of the theory of the firm, there is little basis for any kind of political opinion.

Dan June 4, 2011 at 6:52 pm

None have made a reasonably good argument for BMW to not increase sales through lowered pricing. The firm wants greater sales. BMW is likely to reduce pricing to capture market share. Won’t take long to prove quality was not sacrificed, assuming that the new technology, in fact, does not reduce quality.

John Dewey June 6, 2011 at 9:21 am

I think DJB did in the post just above yours. BMW can gain share of the high-priced auto market by offerring more luxury features at the same original price.

W.E.Heasley June 4, 2011 at 7:25 pm

Remaining with my original answer.

(e) General Motors, Ford, Toyota will become rent seekers looking for subsidies of one kind or another to either lower price or subsidize operations or subsidize profit margins. -Or – General Motors, Ford, Toyota hire Ian Fletcher to author a book entitled “Unfair BMW and Why We Need Tariffs”. Fletcher will go onto lobby Congress for tariffs and eventually marry Lady Gaga.

Bill Woolsey June 4, 2011 at 7:50 pm

If marginal cost is zero, then the profit maximum is where marginal revenue is zero too. And that is the level of output (and price) that maximizes revenue.

If the demand for the cars is simultaneously rising and marginal cost falls, then BMW may well raise prices–but must not as much as they would have if marginal cost hadn’t decreased.

If the demand for BMW’s is perfectly elastic (not likely) then even if demand is the same, the lower marginal cost would result in BMW selling more cars at the same price. (This is trully implausible, though if demand were very, very elastic, the decreaes in price might be very small–perhaps just a few cents.) In this case, production would expand until marginal cost rises back to its intitial value (or a tiny bit less.) This story applies to an individual corn farmer who lowers his marginal cost schedule.

While I suppose it is conceivable that the shift in the marginal cost schedule was so extreme that the price at which profits are maximized would actually result in lower demand because the BMW has no snob appeal, but this is likely to be irrelevant for realistic reductions in marginal cost. A BMW is $75k rather than $80k. Well, who wants a cheap car? Right…

Anyway, these comments make me sad.

Methinks1776 June 5, 2011 at 11:46 pm

Bill,

If BMW produces a superior product at all price points, I fail to see how that will result in lower demand. The snobs are nothing to worry about. They can always be satisfied by carving a niche within the brand – think Maybach. But, the snobs are not the ones who will make you rich and most people want the most reliable car for the money they’re spending – including the snobs.

vikingvista June 6, 2011 at 4:10 am

True. Think founder of Neiman Marcus versus founder of Walmart.

Methinks1776 June 6, 2011 at 9:49 am

Also, think of what’s happened to every single luxury brand that LVMH has bought – and that’s with a huge decline in quality, which is not the case in the test question. Louis Vuitton used make high quality products. Now, it doesn’t and it’s more profitable.

Vance Armor June 4, 2011 at 7:50 pm

Don is absolutely correct in his analysis reformulating Question 2 of the Pop Quiz. Noticeably, he left out everything concerning the patent in his reformulation. It reminds me of the French diplomat who told the American diplomat that he was intrigued by the American proposal on the grounds that the American proposal would work well in practice, but the French government had to reject the American proposal on the grounds that it would not work in theory.

Let’s recapsulate. Yes. Profit maximization occurs where, other things being equal, the marginal cost of a product tends to equal the marginal revenue of that product. Yes. If BMW develops an innovation, other things being equal, the marginal cost curve shifts downward right. This is because the innovation enables BMW to produce the same quantity at a lower cost at each point of the schedule detailing the quantity of cars produced at that point on the schedule. The entire schedule of marginal costs is lowered for each possible unit of output. It shifts downward and to the right. True. The intersection of MC and MR occurs at a lower point on the price schedule and at a higher point on the quantity schedule. BMW must expand production to maximize profits. True. Very good in theory. But you left out the kicker this time Don — i.e. the patent.

Your kicker with the patent raises long term average costs on all competitors, and only those who sell at quantities where the price of each car sold exceeds long term average costs can stay in the market in the long run.

Your question is very good with regard to showing the theory of the firm and how profit maximization occurs where marginal cost equals (or better, tends to equal) marginal revenue.

Catallactic exchange operates in time. The reason that governments have shied away from patents in perpetuity is because they understand that patents in perpetuity will, in the long run, have an effect similar to a state sponsored monopoly grant. Patents are generally only granted for a set number of years. In the days when Marshallian graphs originated — the 1890s — the heuristic demonstrations were air tight, and they still are, to a large extent. But if we introduce the element of time and speak of long run average costs and revenues — as opposed to marginal costs and marginal revenues — the structural element of a monopoly rent due to a patent remains in place, or, better, increases over time. This is the reason that all price theorists worth their salt generally frown on patents in perpetuity. Patents in the twenty-first century have outlived their systemic utility in a voluntary exchange economy. Drug companies are making a killing — literally — through patents. The extraordinary pace of innovations in a twenty-first century market economy almost certainly guarantees that any patent will hike long term average costs for a product — ceteris paribus. Bill Gates is a zillionaire due to patents, and his wealth is not something that we should celebrate as a kind of Horatio Alger story but as a result, in large part, of course, of state sponsored (threat of) violence on his behalf.

Dan June 5, 2011 at 1:32 am

Care to theorize on what would occur to businesses innovative process absent of patents. I would agree that an indefinite patent would far exceed the needs of being an incentive for innovation.

Vance Armor June 4, 2011 at 7:59 pm

Perhaps you could recommend a “pro patent” price theory article and an “anti patent” price theory article in the economics literature. Thank you for your patience and forbearance with me — the classical virtues!

Vance Armor June 4, 2011 at 8:09 pm

BonnieBlueFlag has to understand that price theory cannot operate in a vacuum. One of the beauties of Public Choice Theory is that it is institutionalism done right. Or at least done better. All of the assumptions of economics, whether one speaks of “utility” or “profit” or “exchange” or “cost” are subject to withering and brutal criticisms among political philosophers, the legal academy, psychologists, and ethicists. I am not defending the critics of economics — or better, Hayekian catallactics. We should always ask ourselves the kind of questions, or at least start to ask ourselves the kind of questions that Frank Knight asked about the underlying assumptions of economics. In his old age, the atheist Knight tortured himself by reading religious texts obsessively. Queritur.

Chris O'Leary June 5, 2011 at 2:45 am

You’re ignoring the concept of branding.

BMW is a premium brand and will dilute their brand if they lower their prices precipitously.

Just ask GM how the Catera (the less expensive Cadillac) went.

Sometimes it makes more sense to charge more (in part because the market for affordable cars — or anything — is usually crowded).

DJB June 5, 2011 at 12:52 pm

Consumers will still benefit from lower prices or higher values, see above.

Chris O'Leary June 5, 2011 at 6:41 pm

This doesn’t necessarily follow. The beneficiaries could just be BMWs stockholders as they keep the added margin as profits.

Switch Apple for BMW and you can see that this is true. Apple is another company/brand that has succeeded with a premium pricing strategy.

Chris O'Leary June 5, 2011 at 6:44 pm

Part of the thing is that you seem to be assuming cost-based pricing where the price falls as the cost falls so as to keep the margin constant.

In truth, the best pricing is value-based pricing.

Why should BMW lower their prices without any reason to do so?

I’m not trying to be a nit-picker, but this branding stuff (and consumer behavior and psychology) is something that I see economists gloss over (at their peril).

Daniel Kuehn June 5, 2011 at 6:18 am

I should have noted it at the time, but that was one post where I actually strongly agreed with you against your critics.

Hari MIchaelson June 5, 2011 at 10:51 am

There are a few issues I would like to address.

1. Don has done nothing to address the patent aspect of the question. Don, if you believe that patents are true examples of property, and they are not an aberration of government intervention, then just say so. We don’t need to have an intellectual property argument here, but at least address it. Furthermore, you don’t address the “price” question. You must admit a patent uses government resources. The ticket price of a BMW does not reflect the added cost that each tax payer must pay for BMW’s patent. With this included, the question becomes empirical. Do the cost reductions in BMW’s innovation outweigh the increased costs of patent enforcement? Of course the only way to answer this is with more information…thus “D” has to be correct.

2. To the numerous people who say, “Its econ 103, therefore B is right because the student isn’t that sophisticated.”

This is absurd logic. In basic courses, the questions should be easier. They should not be WRONG. If an economics expert answers this question differently than a student, then it is a poorly worded question. This line of thinking leads to bizarre scenarios. Basically, you’re saying, if a student, who happens to read say…Friedrich Hayek, answers “D” because he has a better grasp of economics than his classmates, he is wrong. This must be the product of some insane government control over education because this borders on the surreal.

1+1=2 !! If you give an arithmetic test to an advance theoretical mathematician, they will not answer differently than a 5th grader (assuming the 5th grader knows math). But in your bizarro fantasy world, this is ok if its econ 103.

This was a poorly worded question. It uses a luxury good, BMW, and it includes government intervention, the patent.

DJB June 5, 2011 at 12:56 pm

By this rational, just about every physics 101 question is a bad or poorly worded question.

Hari Michaelson June 5, 2011 at 6:36 pm

I never went further than physics 102, but that just means physics education is bad.

John Dewey June 6, 2011 at 9:18 am

I’m sure Don will sleep better knowing that you have strongly agreed with him.

LowcountryJoe June 5, 2011 at 10:39 am

I’m quite amazed that a question specifically created for an introductory course, and billed that way, has caused some much over-analyzing by some who will go out of their way to suggest prices will not necessarily be lowered.

So, hypocritically, I will now join the over-analyzing fray with a few thoughts.

1) the direct purchaser of automobiles are the dealers who facilitate the transaction with the end-user consumer (or, possibly, a leasing company that will ‘rent out’ a car).
2) the final cost to an end-user consumer of a BMW is very high relative to other cars in the market. Because of this, if the patented technology being implemented does not cause a significant reduction in costs to the point where a couple of thousand dollars could be reduced from the final price to the end-user, there may only be a very slight increase in demand [as others have claimed]. It may be more advantageous for those in the BMW supply chain to use these saving to increase marketing, offer increased warranty coverage, or increase something else that the end-user sees as valuable without lowering the costs.
3) other manufacturers will take notice of the innovative and patented technology that BMW now uses. And while other car manufacturers wouldn’t be allowed to use this technology unless they make a contractual arrangements with the patent holder, the very idea of a new technology will unlock the creative talents of others in the industry who will go on to develop their own innovations which will, long term, also further the lowering of costs industry-wide.

For the purposes of an introductory course test question, though, the answer Don gives is spot-on and should be acceptable to everyone who is clear-thinking.

Vance Armor June 5, 2011 at 5:14 pm

LowCountryJoe — it wouldn’t have been a complicated question if Don had not inserted the scatalogical element of the patent into the question.

Vance Armor June 5, 2011 at 5:38 pm

If patents are so great, because they reward innovation and spur creativity, why not just grant state prizes — large sums of tax dollars — to those who come up with marketable inventions instead of putting the judicial power behind the patent holder? Either way is an ad hoc system of state intervention. There are no “intellectual property rights” in what Edmund Burke called “natural society.” See E. Burke, A Vindication of Natural Society.

kyle8 June 5, 2011 at 7:55 pm

I suppose the best argument for the issuance of patents is the argument of reality. It is a policy with a long long track record of success. In fact, the success can be very fairly contrasted with societies who have not so rewarded innovation.

This is why I am not a pure libertarian. When theory comes up against long established policy then I always err in favor of what works. Policies which are bad, like the war on drugs, should not be continued, But patents, I think that’s one the government got right.

Vance Armor June 5, 2011 at 5:51 pm

A patent differs greatly from a registered deed at a county courthouse. When a person obtains a deed to land, there is merely a recording of an instrument that puts the public on notice that the land is owned by the grantee (and generally, in the formal language, “his heirs”), and the description of the land is given. Signature of the grantor, proper granting language, definite description language, and at least a perfunctory langauge establishing the consideration (the price) or whether it was a gift, devise or some other kind of conveyance. The county clerk’s seal is required for proper recording. In this system, the government agent acts a servant to effectuate a proper use of knowledge in society. With patents, on the other hand, the government agent, rather than a prior grantor, is the grantor. This grant of “intellectual property” is for a period of time decided by the central planners — 5 years, 10 years, 50 years. The central planners decide what part of the “invention” is patentable. The “describing language” of the grant is decided not by an individual grantor and grantee, against the background information of what can be conveyed, but rather by the government. Rent-seekers (especially the pharmaceutical lobbyists) lobby Congress to narrow or widen what is patentable, both in terms of length of time for patents and in terms of how narrow the language can be to describe the invention. Some intellectual property rights theorists in the legal academy even suggest that it is illegal to sing certain songs in the shower. What a free society.

Hari Michaelson June 5, 2011 at 6:37 pm

Spot on.

Cameron Murray June 5, 2011 at 8:56 pm

I think another commenter who suggested ‘what if marginal cost was zero?’ has a point.

Economists love marginal cost but the structure of real firms does not always match economic theory. What if the marginal cost is actually below the average cost (as it usually is following large capital investments which improve productivity but take some time to be fully utilised)? It makes no sense to price at marginal cost.

If you drop this somewhat unrealistic assumption then BMW does no decrease prices to match MC, as it doesn’t maximise profits.

Another example. Genetically engineered seeds to a mango tree get blown into your backyard and the worlds most productive fruit tree grows. It bears mangoes year round, and they fall to the ground at the perfect moment and the impact does not blemish them.

You live next door to a fruit market which sells mangoes at $5/kilo. The average, and indeed the marginal cost to you to sell your mangoes approximates zero. Do you sell them for zero to maximise profits? No. You price them slightly lower than the existing prices until such time as you either sell all you weekly harvest, or the price is below your competitors costs.

Cameron Murray June 5, 2011 at 9:00 pm

To complete the analogy, if the costs for mango competitors is $3, then you only need to price at $2.99 to maximise profits. In fact, you could possibly price higher (between $3 and $5) if the extra demand created by reducing prices was sufficient to buy all your mangoes.

Forget MC=MR

Vance Armor June 6, 2011 at 9:55 am

Don still has not addressed (1) the patent issue; and (2) its effect on long term average costs of the competition.

Brent Crater June 6, 2011 at 9:57 pm

I’ve been waiting for a discussion of what I, lacking a better name, call the artisan bread effect.

Most bread these days is made through industrial bakeries. These can produce a moderately sized, but limited, set of choices imposed by the limits of the dough-making machinery. If you’re in the market for, e.g., whole wheat bread or potato bread this system can produce a good quality loaf for between roughly $2.00 and $4.00 massing about 20 ounces. (Prices vary over time as stores use these as promotional items.)

If you look around, though, there are two other niches that bread makers try to fill. The more common is the discount bread: very basic loaves of bread, usually white and whole wheat of somewhat lower quality selling for $1.50 to $2.25 or so. This is the default niche assumed in the standard answer to the original question; that prices of other automobiles would fall as other makers would cut their expenses to compete.

The alternative response is to try to create experiences and products that the industrial process does not accommodate. This is the artisan bread; it may contain unusual ingredients like pine nuts or spinach that don’t blend well in a large industrial mixer system. Prices for there are much higher, in the $5 to $7 range for a smaller, 16 ounce, loaf. You will not find potato bread in this section of the market; it’s not their objective.

I can’t rule out that some automakers would respond in the same way and add special items to their cars to justify a premium. What does everyone else think?

Vance Armor June 6, 2011 at 10:17 pm

Brent — I do not think it can be answered well using a Galbraithian type of “contrived wants” narrative. I do believe that a catallactic price theory approach — analyzing the relative price elasticities of demand among the competing brands and quality niches is a better approach. My intuition leads me to believe that bread loaves tend to have relatively high price elasticities of demand among all brands, at least from my shopping (not economic analysis) experience.

Bud June 8, 2011 at 9:58 am

Ok now question #3?

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