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