Willingness to Pay (WTP) represents the maximum price an individual is prepared to pay for a good, reflecting their personal valuation of it. This valuation is subjective and can differ significantly among consumers based on factors such as how important they consider the good, their work ethic, and their available financial resources. A consumer will only purchase a product if its price is less than or equal to their WTP. [1, 2, 7]

Willingness to Pay (WTP)

Gregory King was a 17th-century English official who compiled extensive statistical data on the population and wealth of England. This data became the empirical basis for the Davenant-King Law of Demand.

Gregory King (1648–1712)

Charles Davenant, an English politician from the 17th century, is credited with publishing the Davenant-King Law of Demand in 1699. He utilized the data compiled by Gregory King to articulate the relationship between the supply of a commodity and its price.

Charles Davenant (1656–1714)

Published in 1699 by Charles Davenant based on data from Gregory King, this law articulated the relationship between a crop's harvest size and its market price. It specifically analyzed the price of corn, calculating, for example, that a 10% shortfall in the harvest would result in a 30% price increase.

The Davenant–King Law of Demand

The Law of Demand states that there is an inverse relationship between the price of a product and the quantity that consumers demand. When the price is lower, more consumers are willing to purchase the product, resulting in higher demand. Conversely, as the price rises, the quantity demanded falls. This principle is the reason demand curves are expected to slope downward.

Law of Demand

This diagram illustrates two distinct, parallel demand curves, labeled D and D'. The vertical axis represents the price in pounds, from 0 to 12,000, while the horizontal axis indicates the quantity of consumers, from 0 to 100. The lower demand curve, D, is a downward-sloping line that connects the points (0, 6000) and (60, 0). The upper demand curve, D', is also a downward-sloping line, linking the points (0, 10000) and (100, 0).

A Graph Showing Two Alternative Demand Curves (D and D')

A firm's pricing decision is significantly influenced by the slope of the demand curve, which indicates how sensitive consumer demand is to price changes. If the demand curve is steep, it signifies that a price increase will not cause a substantial decrease in sales. This allows the firm greater power to raise its price without losing many customers.

Impact of Demand Curve Steepness on Pricing Power

The price elasticity of demand, symbolized by epsilon (ε), is a measure of the sensitivity of the quantity demanded of a product to changes in its price. [1, 10, 13] It is calculated as the percentage change in quantity demanded that occurs along the demand curve in response to a 1% increase in price. [1] Because quantity demanded generally falls as prices rise, this value is typically negative. For ease of interpretation, it is often expressed as a positive number. If the elasticity value exceeds one, demand is considered 'elastic,' meaning a 1% price increase results in a quantity demanded decrease of more than 1%. [2] If the value is less than one, demand is termed 'inelastic.' [2]

Price Elasticity of Demand

A consumer survey is a method for estimating product demand, which is especially valuable for new products like cereals or space flights where historical sales data is unavailable. The technique involves asking a large sample of consumers about their willingness to pay at different price points. By analyzing the proportion of respondents willing to purchase at each price, it's possible to construct the entire demand curve for the product.

Estimating a Demand Curve via Consumer Surveys

The data for the Apple Cinnamon Cheerios demand curve originates from a 1996 study by economist Jerry A. Hausman. [7] The study, titled 'Valuation of New Goods Under Perfect and Imperfect Competition,' was included in the book 'The Economics of New Goods,' published by the University of Chicago Press on pages 207-248. [7]

Source of Demand Curve Data for Apple Cinnamon Cheerios (Hausman, 1996)

For simplicity in economic models, both supply and demand curves are frequently depicted as straight lines. In reality, they are more likely to be non-linear. The precise shape of these curves depends on the distribution of valuations among market participants—that is, how willingness to pay (for demand) or willingness to accept (for supply) varies from person to person.

Linearity of Supply and Demand Curves as a Simplification

Figure 8.7 shows the market demand curve for bread, representing the total quantity demanded by all consumers at various prices. Fundamentally, this curve also illustrates the willingness to pay (WTP) of the consumers for each unit of the good. The curve has a downward slope, indicating that as the price falls, more consumers are willing to purchase the product.

The Market Demand Curve for Bread (Figure 8.7) and Consumer Willingness to Pay

This activity presents a scenario involving a hat shop to analyze the consequences of a price adjustment. Initially, the shop sells 20 hats weekly for \$10 per hat. After raising the price to \$12, weekly sales decrease to 15 hats. The task is to use this data to evaluate a series of statements and identify the correct ones.

Activity: Analyzing a Hat Shop's Price Change

The inverse demand function, written as $P = f(Q)$, defines price as a function of quantity. [3] This representation aligns with the standard graphical display of a demand curve, with price on the vertical axis and quantity on the horizontal axis. [1] It specifies the maximum price a firm can set to sell a given quantity of its product. While the direct demand function is used to express price elasticity in terms of price, the inverse demand function is useful for expressing elasticity entirely in terms of quantity.

Inverse Demand Function: Price as a Function of Quantity

The direct demand function, denoted as $Q = D(P)$, expresses the quantity demanded (Q) as a function of price (P). Consistent with the downward-sloping nature of the demand curve, this is a strictly decreasing function. It is derived by rearranging the inverse demand function, $P = f(Q)$, to solve for Q. Thus, the function $D(P)$ is the mathematical inverse of the inverse demand function $f(Q)$. This direct functional form is necessary for the mathematical determination of the market equilibrium price by equating it with the direct supply function.

Direct Demand Function: Quantity as a Function of Price (Q = D(P))

Aggregate demand represents the total expenditure on all goods and services produced within an economy at a given time. [1] It is a macroeconomic concept that sums up the demand from all sectors of the economy. [2, 5]

Definition of Aggregate Demand

A product's demand curve, also known as a demand function, illustrates the relationship between the quantity of items consumers will purchase and every possible price point. [4, 7] A key feature of demand curves is their downward slope, which signifies that as a product's price increases, the quantity consumers demand for it falls. This inverse relationship also means that when a product's available quantity is low, it can be sold at a high price. The curve itself is derived from the willingness to pay (WTP) of each consumer, showing the number of consumers whose WTP is at or above any given price.

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A firm is a key institution in capitalist economies, with an importance that rivals the government's. It serves as a specific method for organizing production, defined by several core characteristics:
* **Private Ownership of Capital:** One or more private individuals own the capital goods used for production.
* **Paid Employment:** The owners hire and direct labor, paying wages or salaries to the employees.
* **Owner's Property:** The goods and services produced are the property of the firm's owners.
* **Market and Profit:** The owners sell the output on markets with the primary objective of making a profit.

Firm

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Microeconomics

Which of the following is NOT a characteristic of a firm?

What is the primary aim of selling the goods and services produced by a firm in the market?

Who directs the employees in a firm?

What is the main role of managers in a firm?

A firm's production process involves utilizing capital goods it owns or rents, like buildings and equipment, and employing workers. Through this process, the firm creates goods and services intended for sale in the market.

Firm's Production Process

The effective operation of firms is fundamentally dependent on the existence of two key institutions: markets and private property. These institutions create the necessary conditions for firms to conduct their business.

Essential Role of Markets and Private Property for Firms

A key feature that sets firms apart from other institutions like families or governments is their dynamic lifecycle. Firms can be created, grow, shrink, or be dissolved with remarkable speed. For instance, a prosperous firm can rapidly scale its operations, expanding from a small team to a large corporation, while an unprofitable one can quickly shrink and even cease to exist.

Dynamic Nature of Firms

This problem involves applying the definition of a firm to determine if a given entity qualifies as one. The process requires examining whether the entity possesses the key characteristics that define a firm, which may involve conducting external research for specific details about the entity.

Identifying Firms Based on Their Defining Characteristics

In capitalist economies, firms are the primary drivers of demand in the labour market, offering jobs to workers who constitute the supply side. This process of matching employers with employees is a foundational function of the firm, but it is only the first step in the employment relationship.

The Firm's Role in the Labour Market: Hiring

A firm is a structured and relatively permanent organization, distinct from temporary gatherings. A key aspect of its structure is a formal decision-making process that includes specific actors and defined hierarchies. This internal organization, which outlines key players and their roles in decision-making, provides a framework for directing the activities of its members.

Firms as Structured and Enduring Organizations

A fundamental question in the economics of the firm investigates why the predominant organizational structure involves capital owners hiring workers, rather than the alternative model where workers own the firm and rent the necessary capital. This question has been practically explored throughout history, with many attempts to establish alternative business models like worker-owned cooperatives.

The Question of Firm Ownership and Structure: Why Capital Hires Labor

In a capitalist economy, the most common productive organization is the traditional firm. However, other forms exist, such as worker-owned cooperatives, which represent a distinct type of firm where employees own the assets and select the management. Alongside these firm structures, there are also non-firm organizations like family businesses, non-profits, and government-owned entities, which are distinguished by their ownership models or primary objectives.

Types of Productive Organizations in Capitalist Economies

Because the profits of a firm legally belong to its owners, they are entitled to the residual income. This residual is what remains after all other contractual costs—such as payments to employees, managers, suppliers, creditors, and taxes—are deducted from the firm's revenues. This status makes the owners the firm's residual claimants.

Owners as Residual Claimants of a Firm

In smaller business structures, it is common for the roles of owner and manager to be combined. In this model, the owner is not just a residual claimant but also takes direct responsibility for making the company's key operational and strategic decisions.

Owner-Managers in Small Enterprises

The dynamics between a firm's owners, managers, and employees are fundamental in determining key outcomes such as wages, work effort, and profitability. Furthermore, the collective result of these internal interactions has a significant influence on the overall economy.

The Firm's Internal Interactions and Their Economic Impact

Co-authored by John Micklethwait and Adrian Wooldridge, 'The Company: A Short History of a Revolutionary Idea' explores the historical evolution of the firm. Published in 2003 in New York by Modern Library, the book explains how this business structure developed into a highly important institution within modern economies.

The Company (Book by Micklethwait and Wooldridge)

A differentiated product is one that possesses unique characteristics that customers value and perceive as unavailable in competing products. This differentiation can be based on design, performance, quality, location, or associated services. The concept applies not only to manufactured goods like cars but also to service providers and retail stores, which can be distinguished by their product selection or the overall shopping experience. [1, 2, 8]

Differentiated Product

Demand Curve

Jack Cohen, the founder of Tesco, started his career in 1919 as a market trader in London's East End, where he famously used his cap-throwing technique to secure the best stall, or 'pitch'. His business philosophy was encapsulated in the motto, ‘Pile it high and sell it cheap’. In 1929, he founded his first Tesco grocery store, marking his formal entry into the retail sector.

Jack Cohen, Founder of Tesco

A demand schedule is a table that presents the quantity (Q) of a good that consumers will demand at various different price points (P).

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