Transcript Document

Chapter 5
The Behavior of Firms
Steven Landsburg,
University of Rochester
Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.
Introduction
• Individuals demand goods and services
• Firms supply goods and services
• Study of firm behavior leads to deeper
understanding of supply
• Assume firms act to maximize profits
– Weigh costs against benefits
– Investigate equimarginal principles
– Use equimarginal principle to decide how
much to produce
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Weighing Costs and Benefits
• How to use inputs to maximize output
• Benefits gained from activity
– Total benefit (TB) from using inputs in a given manner
– Marginal benefit (MB)
• Additional benefit gained from the last unit of activity or last
input used
• Costs incurred from activity
– Total cost (TC) of using inputs in a given manner
– Marginal cost (MC)
• Additional cost associated with the last unit of activity or the
last input used
• Later introduced as slope of TC
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Maximizing Net Gain
• Method I
– Net gain = TB – TC
• Find the maximum net gain and choose to produce at that
level
• If maximum at 2 different levels, choose highest level
• Method II
– Locate MB and MC
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Compare values
Produce where MB = MC
As long as MB > MC, decide to increase production
When MB < MC, no longer good for net gain
Exception to rule – If largest net gain negative, no production
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EXHIBIT 5.1
Maximizing Net Gain
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Equimarginal Principle
• Activity pursued up to the point where MC
= MB
• Circumstances change
– No change in marginal values
– Optimal amount of activity unchanged
• Broad applicability
– Utility and consumer optimum
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Firms in the Marketplace: Revenue
• Total revenue (TR) = Price X Quantity
– Firm can choose either price or quantity
– Price: price at which good is sold
– Quantity: number of goods sold in period
under consideration
• Marginal revenue (MR)
– Additional revenue earned from last item
produced and sold
– Slope of TR
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EXHIBIT 5.3
Maximizing Profits at the Tailor
Dress Company
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Firms in the Marketplace: Costs
• Cost of producing an item is the sum of the costs
of the inputs
– Fixed costs (FC): costs that do not vary with the
quantity of output
• Costs of being in business in the first place
• Ex. rent
– Variable costs (VC): costs that do vary with the
quantity of output
• Costs of actually producing
• Ex. worker’s wages
• Increasing MC
– Additional unit of an activity is more expensive than
the last
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Maximizing Profit
• Profit = TR – TC
• Method I
– Scan profit information
– Choose largest number
– Graphically, find point where distance between TR
and TC is largest
• Method II
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Observe marginal values
Produce where MR = MC
As long as MR > MC, decide to increase production
When MR < MC, no longer good for maximizing profit
Graphically, find point where MR and MC cross
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Changes in Firm’s Behavior
• Changes in fixed cost
– Do not affect firm’s behavior
– Exception: Fixed cost extremely high
• If profits negative, firm will not produce and go out of business
• Sunk costs
– Costs that can no longer be avoided
– Once accepted, do not change behavior
• Changes in variable costs
– Do affect firm’s behavior
– Total cost curve shifts by different amounts at different quantities
• Changes in marginal revenue
– Affects firms behavior
– Anything that affects demand affects marginal revenue
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