7.4 - demand and isoprofit curves for Beautiful
Cars. In the previous video I talked about the
cost structure of this company. In this video I'm
going to talk about the demand side and profit.
So for the demand curve we've got a typical
downward-sloping line: as the price
of Beautiful Cars drops, the demand for them goes
up - a very familiar straightforward demand curve.
Now let's scroll down and
talk about isoprofit curves.
Let's start with the situation that our company
makes no profit at all. That can happen when the
price that they're charging for their car is
the same as the average cost of production,
therefore the average cost curve
here that we introduced from
our previous video represents a case
where our firm makes no profit at all.
But if Beautiful Car starts to charge a
price that is higher than the average cost,
a price that is higher than the unit cost,
the company starts to make profit and that is
represented by these other isoprofit curves. Now
this isoprofit curve represents a scenario where
our firm makes a total profit of $70,000
per day. This other curve represents a
scenario where our company makes $150,000
of profit per day.
Now let's introduce our marginal cost and think
about a specific scenario. In this scenario
our firm produces a small number of cars but makes
a lot of profit on each car that is selling and
that scenario is G. In this case the company is
pricing each car around $7,000 dollars but
each car is costing the company around $4,000
to produce so the company
is making a lot of profit on each car that is
selling and in total it makes a profit of $70,000 per day.
Now we can think of another strategy
that the company can follow and
makes the same amount of profit
per day, and that strategy is K.
In that strategy the company produces a higher
number of cars but makes a
a smaller profit on each car that is selling.
That's represented by a smaller gap between the
price and the average cost curve. Now we can think
about another scenario again, H for instance.
Our company still produces a higher number of cars
but charges a higher price and therefore makes a
higher profit - makes a total profit of $150,000 per
day. Now remember that all these isoprofit curves
are hypothetical: they exist in the entrepreneur's
mind. Remember: they're like indifference curves -
they were hypothetical as well. We introduced
them in Unit 3, and they existed in people's minds.
This is also the same with isoprofit curves:
they are inside the entrepreneur's head.
The only curve that is real here is the average
cost curve and that is determined by the physical
production constraint that exists out there. Now
the important question is: which of these
hypothetical scenarios is going to materialise?
Which of these isoprofit curves is actually
going to happen? That depends on the customer
side - the demand side, so let's scroll down and add
the demand to our model. So we go to 7.5 'Setting
price and quantity to maximize profit'. If you
scroll down you see that we have added the demand
curve to our model. In this case the entrepreneur
finds the point where the demand meets the
highest profit scenario. In other words the
demand curve become tangential to the highest isoprofit
curve and that is represented by point E.
In this case Beautiful Cars were charged around
$5,000 for each of their cars
and they end up producing 32 cars per day and in
total they make a profit of $63,360 per day.
Now it's important to stress that the
Beautiful Car company finds this price
and quantity by trial and error. For instance
let's assume at the beginning they produce
the same quantity of cars (32) but
they charge $4,000.
What's going to happen? People are going to rush to buy
these cars and they find themselves that there
are a lot of other people that want to buy their
cars, so there is an unmet demand at this price.
So they can think of two options: either
increasing their quantity to make more profit
or they produce the same quantity and charge more
for their cars. Let's assume that they go for the
second option. They still produce the same
amount of cars (32) but they increase their
price from around $4,000 to $5,000.
In this case they increase their profit from
$33,000 per day to $63,000 per day.
Now seeing this Beautiful Cars might think that
we can actually further increase our profit by
further increasing our price. Let's assume that
they decide to charge $7,000 for their cars.
So they end up here. What's going
to happen? They're going to find out that not
all of their cars are going to sell. In this
scenario there's not enough demand for their cars
when they price their cars around $7,000. So what's
going to happen? They're going to
go back and reduce their price and eventually
they're going to settle at point E. Let me add
that at point E the slope of the demand curve - that
is the marginal rate of transformation is equal to
the slope of the isoprofit curve - that is the
marginal rate of substitution. Sounds familiar?
This is the same kind of an economic problem
that we encountered in our previous units and
we call it constraint maximization problem. This
is the case where the willingness to pay of someone
matches the constraint that exists out there
and that represents the best possible scenario.