Steven Landsburg, University of Rochester Chapter 5 The Behavior of Firms Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6th edition2 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 edition3 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 edition4 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 edition5 EXHIBIT 5.1Maximizing Net Gain

Landsburg, Price Theory and Applications, 6th edition6 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 edition7 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 edition8 EXHIBIT 5.3Maximizing Profits at the Tailor Dress Company

Landsburg, Price Theory and Applications, 6th edition9 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 edition10 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 edition11 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