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demand curve?
August 15, 2011mnmecon
This is a pretty standard question and its a good bet at some point when you start studying
microeconomics you will get given this question as an exercise. It is also a question that is good to
understand because if you get this you are on the way to getting some of the key concepts about
elasticity and marginal revenue.
The first thing to understand is that, apart from the special case of constant elasticity where the
demand curve is of the form
, the elasticity will vary along different points of the demand
curve. This is true even when the gradient of the demand curve is constant (ie the demand curve is
linear). This is a point that sometimes confuses students about elasticity, they think constant
gradient = constant elasticityno it doesnt.
Here is an example, this is a simple demand function Q = 20-0.5P.
negative value, because when you increase the price, you decrease the quantity, so
negative.
As these changes tend to zero (ie at the margin) we can express the elasticity as
If
then we say the demand is inelastic. If
then it is 'unit elastic'.
If
then it is elastic.
With this demand function,
will be
.
quantity. At the point where the price is 40 and the quantity is 0, the elasticity will be 40/0 x -0.5
which will be infinity. Below point c, the curve is inelastic and gets less elastic the lower the price and
higher the quantity. At the point where the price is 0 and the quantity is 20, the elasticity will be 0/20
x -0.5 which will be 0.
We can now think of this with marginal revenue.
and
so
and
.
.
Notice how the marginal revenue is positive when the demand curve is elastic, it is zero when
the demand curve is unit elastic and it becomes negative when the demand curve is inelastic.
This is the answer to the question. Given that the marginal revenue is the amount of revenue gained
by selling an extra unit, nobody is going to sell an extra unit if the marginal revenue is negative (ie
they lose money by selling it).
You can also think of this in an algebraic way. Given that
to say
so
Now multiply both top and bottom parts of the right hand side of that equation by P so you
get
which can
The right hand side of that equation is the inverse of the elasticity, , so
. This is a
useful equation to remember.
Elastic demand is where
and inelastic demand is where
. So now we can think of
why a monopolist won't produce in the inelastic part of its demand curve. When demand is inelastic
then
so
that
. So the marginal revenue will be negative, and no firm will produce an extra unit if
it means it loses money.