Transcript Behavior of Firms

Chapter 5
The Behavior of
Firms (Producers)
Steven Landsburg,
University of Rochester
Copyright ©2008 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.
Introduction

Individuals demand goods and services


Firms (producers) supply goods and services


Study of consumer behavior leads to deeper
understanding of demand
Study of firm (producer) behavior leads to deeper
understanding of supply
Firms – entities that produce and sell goods and
services, with the goal of maximizing its profits


Profit = Revenue – Cost
The goal of profit maximization enters into every
decision a firm makes.
Benefits and Costs of an Activity



While producing a Good or Service, a firm makes many decisions.
The primary decision a firm faces is how to use what inputs to
maximize output
Using any of its inputs, a firm gets some benefit and incurs some
costs
 Net Gain = Total Benefits – Total Costs

The firm’s objective is to maximizing net gain

Benefits gained from using an input
 Total benefit (TB) from using the input in a given manner
 Marginal benefit (MB) - Defined as the additional benefit
gained from the last unit of the input used
Costs incurred from using the input
 Total cost (TC) of using inputs in a given manner
 Marginal cost (MC) - Defined as the additional cost incurred
for using the last unit of the input

Maximizing Net Gain


Suppose that a farmer makes a decision on how many acres to
use pesticide.
The farmers benefits from and costs of using pesticide are
given in the table below.
Acres
Sprayed
Total
Marginal Total Cost
Benefit ($) Benefit ($)
($)
Marginal
Cost ($)
0
Net Gain
($)
0
0
0
1
6
6
3
3
3
2
11
5
6
3
5
3
15
4
9
3
6
4
18
3
12
3
6
5
20
2
15
3
5
6
21
1
18
3
3
Maximizing Net Gain

The farmer’s total and marginal benefits and costs
can plotted as follows
Maximizing Net Gain

Net gain = TB – TC

Method I



Find the maximum net gain and choose to produce at that
level
If maximum at 2 different levels, choose the highest level
Method II

Produce where MB = MC
 As long as MB > MC, decide to increase production
 When MB < MC, no longer good for net gain
Equimarginal Principle

If an activity is worth pursuing at all, then it should
be pursued up to the point where MC = MB

If circumstances change in a way that does not affect
anything marginal and if an activity remains worth
pursuing at all, then the optimal amount of that
activity is unchanged

Broad applicability
 Utility and consumer optimum
Firms in the Marketplace: Revenue


The objective of a firm is to maximize profit
Profit = Revenue - Cost
Revenue – The proceeds collected by a firm when it
sells its products
Total Revenue = Price × Quantity
TR = P × Q
Marginal revenue - Additional revenue earned
from the last item produced and sold
MR = ∂TR/ ∂Q = Slope of TR
TR  ( P  Q)

P
Q
Q
Firms in the Marketplace: Costs

Cost of producing an item is the sum of the costs of the inputs
Total Cost = Fixed Costs + Variable Costs
TC = FC + VC
Marginal Cost = ∂TC/ ∂Q = Slope of TC

Fixed cost (FC): The cost of fixed inputs; it does not vary
with the quantity of output
 Costs of being in business in the first place
 Example – Rent of the factory or farmland
 Some fixed costs are sunk (unavoidable)

Variable cost (VC): The sum of expenditure on variable
inputs; it varies with the quantity of output
 Costs of variable inputs, such as labor, raw materials
Example
Quantity Price ($) TR($)
Demanded
MR ($)
0
TC ($)
MC ($) Profit ($)
2
1
10
10
10
3
1
7
2
9
18
8
5
2
13
3
8
24
6
8
3
16
4
7
28
4
12
4
16
5
6
30
2
17
5
13
6
5
30
0
23
6
7
7
4
28
-2
30
7
-2
8
3
24
-4
38
8
-14
Maximizing Profits
Maximizing Profit

Profit = TR – TC

Method I:
 Produce the quantity where profit (i.e., the distance
between TR and TC) is the largest

Method II:
 Produce the quantity where MR = MC
 Graphically, the point where MR and MC intersect
 As long as MR > MC, decide to increase production
 When MR < MC, no longer good for maximizing
profit
Changes in Firm’s Behavior




Changes in fixed cost - Shifts TC, but leaves MC unchanged
 Do not affect firm’s behavior
 Exception: Fixed cost extremely high
 If profits negative, firm will shutdown and exit the market
at some point
Sunk costs – Sunk costs are sunk
 Costs that can no longer be avoided
 Once accepted, do not change behavior
Changes in variable costs – Affects both TC and MC
 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