Economics of the Firm Some Introductory Material

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  • Slide 1
  • Economics of the Firm Some Introductory Material
  • Slide 2
  • Introducing homo economicus.also known as Economic Man Economic man is a RATIONAL being
  • Slide 3
  • Every decision we make involves both incremental benefits and costsif we are acting rationally, we will undertake any action where the benefits outweigh the costs. Example: Suppose that you have been wandering in the desert for 5 days when you come across a lemonade stand. How much would you pay for a glass of lemonade?
  • Slide 4
  • Utility is a function of lemonade (among other things) A glass of lemonade will raise your utility A glass of lemonade isnt free..it has a price You will buy a glass of lemonade as long as the benefits are greater than the costs
  • Slide 5
  • We can complicate the example by adding an alternative choicea hot dog stand Utility is a function of lemonade and hot dogs (among other things) A glass of lemonade will raise your utility Every dollar spent on lemonade is a dollar that wont be spent on hot dogs You will buy a glass of lemonade as long as the benefits are greater than the costs
  • Slide 6
  • In either case, we can say that, given a representation of individual tastes, price should have a negative relationship with quantity purchased Utility is a function of lemonade and hot dogs (among other things) Rational Behavior (-) Purchases of lemonade are negatively related to the price of lemonade and positively related to the price of hot dogs (+)
  • Slide 7
  • We can easily add another variable to our demand storymost of us are constrained by our disposable income. Expenditures on Lemonade Expenditures on Hot Dogs Available Income (Constraint) (Preferences) Rational Behavior (-) Purchases of lemonade are negatively related to the price of lemonade and positively related to income and the price of hot dogs (+) +
  • Slide 8
  • We have a similar situation on the supply sidewith one complication. Managers receive compensation from the firm Managers provide effort to the firm Stockholders/Bondholders provide capital for the firm Stockholders/Bondholders receive payments from the firm Stockholders own the company, but managers make the decisionshow do we align their incentives?
  • Slide 9
  • If we assume that the institutional details have been worked out, then the job of the decision maker is to maximize firm value Current Profits Profits one year in the future Risk adjusted rate of return Profits two years in the future
  • Slide 10
  • While it is not necessary, it is sufficient to say that maximizing each years profits will maximize firm value Price times quantity equals current revenues Fixed costs (overhead) is not affected by the level of sales and, hence, has no impact on sales decisions Variable costs are influenced by sales decisions As with the average consumer, a firms decisions are made at the margin!!!
  • Slide 11
  • For each sale that is made, it must be profitable at the margin. For now, lets assume that the firm has no control over the price it charges As with the average consumer, a firms decisions are made at the margin!!! How does an additional sale affect revenues? How does an additional sale affect costs? A sale will be made as long as it has a bigger impact on revenues than costs.
  • Slide 12
  • In either case, we can say that, given a representation of a firms cost structure, price should have a positive relationship with sales (higher price raises profit margin) while anything that influences costs at the margin should have a negative relationship with sales Rational Behavior (-) Sales of lemonade are positively related to the price of lemonade and negatively related to marginal costs Costs are a function of wages, material prices, etc. (+)
  • Slide 13
  • A Demand Function represents the rational decisions made by a representative consumer(s) Quantity Purchased Is a function of Market Price (-) Income (+) For example, suppose that at a market price of $2.50, an individual with an annual income of $50,000 chooses to buy 5 glasses of lemonade per week.
  • Slide 14
  • A Demand Curve is simply a graphical representation of a demand function For example, suppose that at a market price of $2.50, an individual with an annual income of $50,000 chooses to buy 5 glasses of lemonade per week. Quantity Price $2.50 5
  • Slide 15
  • A Demand Curve is simply a graphical representation of a demand function Suppose that an increase in the market price from $2.50 to $2.75 causes this individual to reduce his/her lemonade purchases to 4 glasses per week Quantity Price $2.50 5 $2.75 4
  • Slide 16
  • Demand curves slope downwards this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively Quantity Price $2.50 5 $2.75 4
  • Slide 17
  • A Supply Function represents the rational decisions made by a representative firm(s) Quantity Supplied Is a function of Market Price (+) Marginal Costs (-) For example, suppose that at a market price of $2.00, a firm facing a wage rate of $6/hr will supply 200 glasses per week.
  • Slide 18
  • A Supply Curve is simply a graphical representation of a supply function Quantity Price $2.00 200 For example, suppose that at a market price of $3.00, a firm facing a wage rate of $6/hr will supply 200 glasses of lemonade per week.
  • Slide 19
  • A Supply Curve is simply a graphical representation of a supply function Suppose that an increase in the market price from $3.00 to $3.90 causes this firm to increase its lemonade sales to 250 cups per week Quantity Price $2.00 200 $3.00 250
  • Slide 20
  • Supply curves slope upwards this reflects the positive relationship between price and quantity. Elasticity of Supply measures this effect quantitatively Quantity Price $2.00 200 $3.00 250
  • Slide 21
  • Quantity Price $2.00 $3.00 Quantity Price 25,000 20,00025,000 $2.50 $2.75 20,000 Suppose that the overall market consists of 5,000 identical lemonade drinkers and 100 lemonade suppliers At a price of $2.50, each of the 5,000 lemonade drinkers buys 5 glasses per week. At a price of $3.00, each of the 100 lemonade suppliers is willing to sell 250 glasses per week.
  • Slide 22
  • Quantity Price Given the behavior of suppliers and consumers, the market price would need to settle in between $2.50 and $2.75 $2.00 20,000Q>25,000 At a price of $2.00, total supply is 20,000, but demand is at least 25,000
  • Slide 23
  • Quantity Price Given the behavior of suppliers and consumers, the market price would need to settle in between $2.50 and $2.75 $3.00 Q

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