1. Demand and Elasticity A high cross elasticity of demand [between two goods indicates that they] compete in the same market. [This can prevent a supplier of one of the products] from possessing monopoly power over price. U.S. SUPREME COURT, DUPONT CELLOPHANE DECISION, 1956 Demand and Elasticity A high cross elasticity of demand [between two goods indicates that they] compete in the same market. [This can prevent a supplier of one of the products] from possessing monopoly power over price. U.S. SUPREME COURT, DUPONT CELLOPHANE DECISION, 1956

2. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = ●Elasticity = measure of the responsiveness of one variable to changes in another variable ●Price elasticity of demand = %  quantity %  price Elasticity: The Measure of Responsiveness

3. FIGURE 1(a): The Hypothetical Demand Curves for Film 41.50 10 $20 Price per Package Quantity Demanded D f D f b a Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

4. FIGURE 1(b): The Hypothetical Demand Curves for Film 430 10 $20 Quantity Demanded Price per Package D S D S B Copyright© 2006 South-Western/Thomson Learning. All rights reserved. A

5. Elasticity: The Measure of Responsiveness ●Elastic demand = price elasticity of demand > 1 ●Inelastic demand = price elasticity of demand < 1 ●Elastic demand = price elasticity of demand > 1 ●Inelastic demand = price elasticity of demand < 1

6. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity: The Measure of Responsiveness ●Equation for Price Elasticity of Demand ♦%  Quantity  %  Price or ♦[(Q 1 - Q 0 ) / (average of Q 1 and Q 0 )] [(P 1 - P 0 ) / (average of P 1 and P 0 )] ●Equation for Price Elasticity of Demand ♦%  Quantity  %  Price or ♦[(Q 1 - Q 0 ) / (average of Q 1 and Q 0 )] [(P 1 - P 0 ) / (average of P 1 and P 0 )]

7. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Percentages calculated in terms of the averages of the prices and quantities ●Minus sign dropped ●Percentages calculated in terms of the averages of the prices and quantities ●Minus sign dropped Elasticity: The Measure of Responsiveness

8. FIGURE 2(a): Sensitivity of Slope to Units of Measurement 2,0001,5001,000 D D 500 0 10 9 8 17 16 15 14 13 12 11 7 6 5 4 3 2 1 $18 (a) Pizzas per Week Price per Pizza 3,0002,500 360 280 B A Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

9. FIGURE 2(b): Sensitivity of Slope to Units of Measurement 2,0001,5001,000 D D 500 0 10 9 8 17 16 15 14 13 12 11 7 6 5 4 3 2 1 $18 (b) Slices of Pizza per Week Price per Pizza 2,5003,000 2,8802,240 A B Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

10. ●The Relationship between Elasticity and Slope ♦Slope depends upon specific units while elasticity does not. ♦If a demand curve has a constant slope (straight-line), the elasticity is not constant. ♦If a demand curve has a constant elasticity (unit elastic), the slope is not constant. ●The Relationship between Elasticity and Slope ♦Slope depends upon specific units while elasticity does not. ♦If a demand curve has a constant slope (straight-line), the elasticity is not constant. ♦If a demand curve has a constant elasticity (unit elastic), the slope is not constant. Price Elasticity of Demand and the Shapes of Demand Curves Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

11. TABLE 1: Estimates of Price Elasticities Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

12. FIGURE 3: Demand Curves with Different Elasticities Price C B A C' A' B' $6 4 3 7542 1 Straight- line demand curve (c) Quantity Demanded 0 D D $0.75 DD “Perfectly elastic” demand curve (b) Quantity Demanded Price 0 “Perfectly inelastic” demand curve (a) Quantity Demanded Price D D 900 Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

13. FIGURE 3(d): Unit Elastic Demand Curve Unit- elastic demand curve U'147 D D $30 10 20 Quantity Demanded Price 0 (d) S T U Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

14. Price Elasticity of Demand ●  price   revenues if the demand curve is elastic ●  price   revenues if the demand curve is inelastic ●  price  0  revenues if the demand curve is unit elastic ●  price   revenues if the demand curve is elastic ●  price   revenues if the demand curve is inelastic ●  price  0  revenues if the demand curve is unit elastic

15. FIGURE 4: An Elastic Demand Curve 5 12 Quantity Demanded Price $6 1 2 3 4 40 U W D D R T S V Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

16. What Determines Demand Elasticity? ●Nature of the good ●Availability of close substitutes ●Fraction of income absorbed ●Passage of time ●Nature of the good ●Availability of close substitutes ●Fraction of income absorbed ●Passage of time

17. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity as a General Concept ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity ♦Income elasticity of demand = %  quantity demanded %  income ●Price Elasticity of Supply ♦Price elasticity of supply = %  quantity of supply %  price ●Elasticity can be used to measure the responsiveness of anything to anything else. ●Income Elasticity ♦Income elasticity of demand = %  quantity demanded %  income ●Price Elasticity of Supply ♦Price elasticity of supply = %  quantity of supply %  price

18. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Elasticity as a General Concept ●Cross Elasticity of Demand ♦Cross elasticity of demand (for product X to a change in the price of product Y) = %  quantity demanded of X %  price of Y ♦If two goods are substitutes, their cross elasticity of demand is positive. ♦Negative if goods are complements ●Cross Elasticity of Demand ♦Cross elasticity of demand (for product X to a change in the price of product Y) = %  quantity demanded of X %  price of Y ♦If two goods are substitutes, their cross elasticity of demand is positive. ♦Negative if goods are complements

19. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Changes in Demand: Movements Along vs Shifts ●  price  movement along the demand curve ●  any other factor that affects spending decisions  shift between demand curves ●  price  movement along the demand curve ●  any other factor that affects spending decisions  shift between demand curves

20. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Changes in Demand: Movements Along vs Shifts ●Demand Shifters ♦Consumer incomes rise ♦Tastes change in favor of the good ♦The price of substitute goods ♦The price of complementary goods ●Demand Shifters ♦Consumer incomes rise ♦Tastes change in favor of the good ♦The price of substitute goods ♦The price of complementary goods

21. FIGURE 5: Shifts in a Demand Curve D 0 D 0 (b) Quantity of Sweaters Price D 1 D 1 S D 0 D 0 (a) Quantity of Sweaters in Thousands Price $35 28 6040 R UT D 2 D 2 Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

22. The Demand Curve and Economic Decision Making ●The demand curve shows the quantity of demand buyers would be ready and willing to purchase at different prices during the same time period. ●Those cannot afford to buy are not considered to be demanding the good ●The demand curve shows the quantity of demand buyers would be ready and willing to purchase at different prices during the same time period. ●Those cannot afford to buy are not considered to be demanding the good

23. Production Costs: Key Factor for Supply Analysis Of course, that’s just an estimate. The actual cost will be somewhat more. AUTO MECHANIC TO CUSTOMER Production Costs: Key Factor for Supply Analysis Of course, that’s just an estimate. The actual cost will be somewhat more. AUTO MECHANIC TO CUSTOMER

24. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●The Economic Short Run vs the Long Run ♦Short run ■a period of time during which some of the firm’s cost commitments will not have ended. ■In the short run, output can change but production processes are fixed. ●The Economic Short Run vs the Long Run ♦Short run ■a period of time during which some of the firm’s cost commitments will not have ended. ■In the short run, output can change but production processes are fixed.

25. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●The Economic Short Run vs the Long Run ♦Long run ■a period of time long enough for all of the firm’s commitments to come to an end. ■In the long run, all inputs can be varied and production processes can be changed. ●The Economic Short Run vs the Long Run ♦Long run ■a period of time long enough for all of the firm’s commitments to come to an end. ■In the long run, all inputs can be varied and production processes can be changed.

26. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Short-run versus Long-run Costs ●Fixed Costs and Variable Costs ♦Total costs = fixed costs + variable costs ♦Fixed costs = costs that cannot be changed ♦Variable costs = costs that can be changed ♦In the short run, some costs are fixed. In the long run, all costs are variable. ●Fixed Costs and Variable Costs ♦Total costs = fixed costs + variable costs ♦Fixed costs = costs that cannot be changed ♦Variable costs = costs that can be changed ♦In the short run, some costs are fixed. In the long run, all costs are variable.

27. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Input Quantities and Total, Average, and Marginal Cost Curves ♦Total cost = the total cost (including opportunity cost) of producing any level of output when inputs are optimally employed ♦Average cost = total cost per unit of output ♦Marginal cost = increase in total cost from producing an additional unit of output ●Input Quantities and Total, Average, and Marginal Cost Curves ♦Total cost = the total cost (including opportunity cost) of producing any level of output when inputs are optimally employed ♦Average cost = total cost per unit of output ♦Marginal cost = increase in total cost from producing an additional unit of output Cost and Its Dependence on Output

28. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 3: Al’s (Variable) Cost Schedules Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

29. FIGURE 4: (a) Al’s Total Variable Cost Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TC (a) Total Variable Cost per Year (thousands $) Quantity of Garages 108642 200 180 160 140 120 100 80 60 40 20 0

30. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 4(b): Al’s Average Variable Cost Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. C D AVC (b) Average Variable Cost per Garage (thousands $) Quantity of Garages 108642 30 25 20 15 10 5 0

31. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 4(c): Al’s Marginal Variable Cost Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (c) Marginal Variable Cost per Added Garage (thousands $) Quantity of Garages 108642 50 45 40 35 30 25 20 15 10 5 0 MVC

32. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Total cost = total fixed cost + total variable cost ●Total fixed cost: constant over all levels of output. ●Total cost = total fixed cost + total variable cost ●Total fixed cost: constant over all levels of output. Input Quantities and Total, Avg, and Marginal Cost Curves Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

33. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 5(a): Fixed Costs: Total Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TFC (a) Total Fixed Cost per Year (thousands of $) Output 10864975312 14 12 10 8 6 4 2 0

34. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Average fixed cost = total fixed cost per unit of output ●Average fixed cost falls as output rises ●Average fixed cost = total fixed cost per unit of output ●Average fixed cost falls as output rises Input Quantities and Total, Avg, and Marginal Cost Curves Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

35. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 4: Al’s Fixed Costs Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

36. FIGURE 5(b): Fixed Costs: Average Copyright © 2006 South-Western/Thomson Learning. All rights reserved. AFC (b) Average Fixed Cost per Garage (thousands $) Output 10864975312 14 12 10 8 6 4 2 0

37. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●A typical average cost curve declines at first because average fixed costs decline. ●It then reaches a minimum and begins to rise because of decreasing marginal returns. ●A typical average cost curve declines at first because average fixed costs decline. ●It then reaches a minimum and begins to rise because of decreasing marginal returns. The Average Cost Curve in the Short and Long Run Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

38. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Costs differ in the short and long runs, because in the long run, more adjustments can be made. ●The long-run average cost curve shows the lowest possible short-run average cost corresponding to each output level. ●Costs differ in the short and long runs, because in the long run, more adjustments can be made. ●The long-run average cost curve shows the lowest possible short-run average cost corresponding to each output level. The Average Cost Curve in the Short and Long Run Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

39. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 6: Short-Run and Long- Run Average Cost Curves Copyright © 2006 South-Western/Thomson Learning. All rights reserved. V B S Average Cost per Pound of Chicken $0.40 0.35 Output in Pounds of Chicken 10040 0 U L W G T

40. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Economies of Scale ●Economies of scale = output rises faster than the common rate of growth of all the inputs. ●Economies of scale = increasing returns to scale ●Economies of scale  long-run declining average cost curves ●Economies of scale = output rises faster than the common rate of growth of all the inputs. ●Economies of scale = increasing returns to scale ●Economies of scale  long-run declining average cost curves

41. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 7: 3 Possible Shapes for the Long-Run AC Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Long-Run Average Cost (c) Quantity of Output Decreasing returns to scale Long-Run Average Cost (b) Quantity of Output Constant returns to scale Long-Run Average Cost (a) Quantity of Output Increasing returns to scale AC

42. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●All points on the analytical cost curve (used in economic analysis) refer to the same period of time. ●An historical cost curve, showing the actual relationship between cost and output at different periods of time, is probably not a good indicator of the analytical cost curve. ●All points on the analytical cost curve (used in economic analysis) refer to the same period of time. ●An historical cost curve, showing the actual relationship between cost and output at different periods of time, is probably not a good indicator of the analytical cost curve. Historical Costs versus Analytical Costs Curves Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

43. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Real business situations are more complex than those outlined in this chapter, and the quality of the available information is less precise. ●Yet when managers are doing their jobs well and the market is functioning smoothly, these models are a good approximation to the real world. ●Real business situations are more complex than those outlined in this chapter, and the quality of the available information is less precise. ●Yet when managers are doing their jobs well and the market is functioning smoothly, these models are a good approximation to the real world. Cost Minimization in Theory and Practice Copyright© 2006 South-Western/Thomson Publishing. All rights reserved.

44. Output, Price, and Profit: The Importance of Marginal Analysis Business is a good game...You keep score with money. NOLAN BUSHNELL, FOUNDER OF ATARI Output, Price, and Profit: The Importance of Marginal Analysis Business is a good game...You keep score with money. NOLAN BUSHNELL, FOUNDER OF ATARI

45. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Price and Quantity: One Decision, Not Two ●Firms face a demand curve on which price and quantity are related. ●They can choose either price or quantity, but not both. ●Firms face a demand curve on which price and quantity are related. ●They can choose either price or quantity, but not both.

46. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 1: Demand Curve for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 15 25 16 D D Profit maximum 5 5 Output, Garages Marketed per Year Price per Garage (thousands $) 10987643210 20 19 22 26 30 35 i h g e f d c b a j

47. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Simplifying assumption: maximum total profit is the firm’s goal. ●Total profit = total revenue - total costs ●Economic profit  accounting profit ●Simplifying assumption: maximum total profit is the firm’s goal. ●Total profit = total revenue - total costs ●Economic profit  accounting profit

48. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Revenue ♦Total Revenue = P  Q ♦Average Revenue = TR/Q = (P  Q)/Q = P ♦Marginal Revenue = change in total revenue from adding one more unit of output. ●Total, Average, and Marginal Revenue ♦Total Revenue = P  Q ♦Average Revenue = TR/Q = (P  Q)/Q = P ♦Marginal Revenue = change in total revenue from adding one more unit of output.

49. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 1: Demand for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

50. FIGURE 2: Total Revenue Curve for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TR A B C D E F G H I J 5 Total Revenue per Year (thousands $) Output, Garages Sold per Year 10987643210 20 40 60 80 100 120 140

51. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Total, Average, and Marginal Cost ♦The shapes of the cost curves mean that there is some size for the firm that is most efficient. ♦Firms that are smaller or larger than this optimal size will have higher average costs. ●Total, Average, and Marginal Cost ♦The shapes of the cost curves mean that there is some size for the firm that is most efficient. ♦Firms that are smaller or larger than this optimal size will have higher average costs.

52. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 2: Al’s Total, Average, and Marginal Costs Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

53. FIGURE 3(a): Cost Curves for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TC (a) Total Cost Output, Garages per Year 5 Total Cost per Year (thousands $) 10987643210 20 40 60 200 180 160 140 120 100 80

54. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(b): Cost Curves for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (b) Average Cost Output, Garages per Year 5 Average Cost per Garage (thousands $) 10987643210 5 15 45 40 35 30 25 20 AC

55. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 3(c): Cost Curves for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved. MC (c) Marginal Cost Output, Garages per Year 5 Marginal Cost per Added Garage (thousands $) 10987643210 5 15 45 50 40 35 30 25 20

56. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total Profit: Keep Your Eye on the Goal ●Maximization of Total Profits ♦Profits typically increase with output, then fall. ♦Some intermediate level of output, therefore, generates the maximum profit. ●Maximization of Total Profits ♦Profits typically increase with output, then fall. ♦Some intermediate level of output, therefore, generates the maximum profit.

57. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 3: TR, Costs, and Profit for Al’s Garages Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

58. Marginal Analysis and Maximization of Total Profit ●Marginal profit is the slope of the total profit curve. ●Profit is at a maximum when the marginal profit is zero. ●Marginal profit is the slope of the total profit curve. ●Profit is at a maximum when the marginal profit is zero.

59. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 4(a): Profit Maximization Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) 10987643210 200 180 160 140 120 100 80 60 40 20 74 B 96 A

60. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 4(b): Profit Maximization Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 5 (b) Total Profit Output, Garages per Year Total profit F D E C 10 9 876432 1 –80 –60 –40 –20 0 20 40 Total Profit per Year (thousands $) M 34

61. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Analysis and Maximization of Total Profit ●Optimum Marginal Revenue and Marginal Cost ♦If MR > MC,  production   profits ♦If MR < MC,  production   profits ●Profit maximizing level of output: MR = MC ●Optimum Marginal Revenue and Marginal Cost ♦If MR > MC,  production   profits ♦If MR < MC,  production   profits ●Profit maximizing level of output: MR = MC

62. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 4: Al’s Marginal Revenue and Marginal Cost Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

63. FIGURE 5(a): Profit Maxim: Another Graphical Interpretation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Output, Garages per Year (a) Marginal Revenue and Marginal Cost 5 MR and MC per Garage per Year (thousands $) 1098764321 –10 0 10 20 30 40 50 MR MC E

64. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 5(b): Profit Maxim: Another Graphical Interpretation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) 10987643210 200 180 160 140 120 100 80 60 40 20 74 B 96 A

65. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. FIGURE 5(c): Profit Maxim: Another Graphical Interpretation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 5 (b) Total Profit Output, Garages per Year Total profit F D E C 10 9 876432 1 –80 –60 –40 –20 0 20 40 Total Profit per Year (thousands $) M 34

66. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Analysis and Maximization of Total Profit ●Finding the Optimal Price from Optimal Output ♦MR = MC: rule for determining the level of output ♦Demand curve  price buyers will pay to purchase that level of output ♦Both output and price are now determined for the profit maximizing firm. ●Finding the Optimal Price from Optimal Output ♦MR = MC: rule for determining the level of output ♦Demand curve  price buyers will pay to purchase that level of output ♦Both output and price are now determined for the profit maximizing firm.

67. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Logic of Marginal Analysis & Maximization ●If a decision is to be made about the quantity of some variable, then maximize net benefit. ●Net benefit = total benefit - total cost ●To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost. ●If a decision is to be made about the quantity of some variable, then maximize net benefit. ●Net benefit = total benefit - total cost ●To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost.

68. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Logic of Marginal Analysis & Maximization ●Application: Fixed Cost and Profit Maximization ♦An increase in fixed costs does not change optimal output or price because it does not affect marginal costs. ●Application: Fixed Cost and Profit Maximization ♦An increase in fixed costs does not change optimal output or price because it does not affect marginal costs.

69. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 5: Rise in Fixed Cost: Total Profits Before and After Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

70. FIGURE 6: Fixed Cost Does Not Affect Profit-Maximizing Output Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 51098764321 Profit with a fixed cost Profit with zero fixed cost N Total Profit per Year (thousands $) Output in Garages per Year M 0 40 20

71. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Fundamental Role of Marginal Analysis ●Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results. ●For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost. ●Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results. ●For example, a new activity will add to profits if it more than covers its marginal cost, not the fully allocated average cost.

72. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The Fundamental Role of Marginal Analysis ●Any problem involving optimization can be illuminated with marginal analysis. ●The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses. ●Any problem involving optimization can be illuminated with marginal analysis. ●The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses.

73. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Theory and Reality: A Word of Caution ●Business people seldom use marginal analysis in a literal sense. ●They often rely on intuition and hunches. ●But these theories can be used to understand and predict behavior. ●Business people seldom use marginal analysis in a literal sense. ●They often rely on intuition and hunches. ●But these theories can be used to understand and predict behavior.

74. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. The End ???