The traditional price theory assumes that every firm produces a single product. However, in the real world we see most firms produce more than one product. Some produce hundreds of products.
The multiple products of a firm can be different sizes, models, and types etc. of the same general class.
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Again, a firm’s multiple products can be of physically quite’ dissimilar products. Each single product has a market.
In the context of changing markets, changing costs, changing consumer tastes, and changing product designs, firms are constantly looking for new markets to explore with new or existing products.
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It is argued that what a firm has to sell is not so much its product as its capacity and know-how in production.
Since most firms produce and sell more than one product, it is essential to re-examine our traditional model of a single product firm, which is in equilibrium when the marginal cost of production for that item is equal to the marginal revenue derived from its sale.
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This assumption breaks down when the firm has idle capacity which may be used to produce completely new product or new models of existing products.
When idle capacity exists, the firm is faced with the challenge of making profitable use of these otherwise wasted resources. So long as the new product can be sold at a price which exceeds the true marginal cost of producing and selling it, the profitability of the firm will be increased by its adoption.
A range of alternative contributing the most to profitability is chosen. In an analysis of the cost of adopting various alternatives it is imperative that true marginal costs be considered, since the decision to add a new product or drop some existing products, may well have an impact on the sales of a firm’s remaining’ outputs.
The argument that a firm is selling its productive capacity, as developed by E.W. Clemens, assumes certain conditions. First, resources of the firm should be readily convertible to making a range of products.
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In other words, the productive resources of the firm may be transferred rather easily from one product to another, thereby facilitating easy adaptation to changing markets and product demands.
This means that a good part of the equipment of the firm is the general purpose equipment and that labour and management are versatile.
A second condition is that the firm normally has some idle equipment not fully utilised. This amounts to relaxing the rigid profit-maximising assumption.
Let us assume that a firm has one product and 60 to 70 per cent of the plant capacity is being utilised and now examine the decision to add additional products. Marginal revenue and marginal cost for the one product are equal.
With its idle capacity of plant, and personnel, the firm can expand production with only a small additional cost. Some of the idle capacity can be used to produce a second product for a second market provided that the demand in the second market is above marginal cost.
More of the idle capacity can be put to work on a third product, a fourth product, a fifth product and so on. Instead of reducing prices and increasing output for an existing product, it will invade new markets where price is greater than marginal cost. We may assume that new markets are invaded in order of their profitability.
Hence, the firm does not reach an equilibrium situation until there are no more markets available where price exceeds marginal cost.
The line EMR represents a line of equal marginal revenue. Since we have assumed that new product markets were entered in order of their profitability, the prices charged for the five products are arranged in declining order from and the elasticity of demand increases from D1 to D5.
The EMR line is determined by the intersection of the firm’s marginal cost curve and the marginal revenue curve for the last product market which may be profitably served. Theoretically this would be the one with the most elastic demand, D5.
If D5 is perfectly elastic, then this is marginal market or the last profitable new product market. In such a case price is equal to MR=MC.
If the marginal market is less than perfectly elastic, there exists the possibility of some remaining market which may be interfered where price exceeds marginal cost.
In our figure the prices of five products are shown. Note that the fifth product has a price just above marginal cost.
The more elastic its demand, the closer would be the price of the marginal product approach marginal cost. For part of its output, therefore, the multiple-product firm operates like the competitive firm, bringing one of its prices close to marginal cost.