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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 Landsburg, Price Theory and Applications, 6th edition 2 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 Landsburg, Price Theory and Applications, 6th edition 3 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 • • • • • 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 Landsburg, Price Theory and Applications, 6th edition 4 EXHIBIT 5.1 Maximizing Net Gain Landsburg, Price Theory and Applications, 6th edition 5 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 Landsburg, Price Theory and Applications, 6th edition 6 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 Landsburg, Price Theory and Applications, 6th edition 7 EXHIBIT 5.3 Maximizing Profits at the Tailor Dress Company Landsburg, Price Theory and Applications, 6th edition 8 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 Landsburg, Price Theory and Applications, 6th edition 9 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 – – – – – 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 Landsburg, Price Theory and Applications, 6th edition 10 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 Landsburg, Price Theory and Applications, 6th edition 11