Economics of the Firm

Economics of the Firm The Basics: Supply & Demand

Introducing homo economicus….also known as “Economic Man” Economic man is a RATIONAL being

The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives – i.e. they respond to opportunities with Economic Profit Economic Profit = (Expected) Benefit – Opportunity Cost Opportunity cost = Direct (Money) Costs + Implicit Costs In other words, think about opportunity cost as the value of ALL the resources that have been consumed

Example: What would be the opportunity cost of attending Notre Dame as an undergraduate? Do students have an incentive to go to Notre Dame? So if you wanted a 10% return on your college education, you would need to earn $22,000 a year more per year after college $55,260 x 4 = $221,040 Is this right?

Example: What is IBM’s opportunity cost? Is IBM earning economic profit? Current Stock Price: $166 Shares Outstanding: 1,287M * In Millions

“Economics deals with the Allocation of scarce resources to satisfy unlimited wants”

“You can’t always get what you want…” - Mick Jagger Consumers have limited incomes to spend on a wide variety of goods and services (both now and in the future) Workers have a finite number of hours in the day to work, relax, go to school, etc Firms have finite capacity and limited financial resources, to produce goods and services The economy as a whole has a finite number of resources trying to satisfy a population with unlimited wants!

If we can’t have everything we want, so we need to decide what to do with the limited resources we do have. Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare Under certain circumstances, the freemarket process guarantees this Can we trust markets to produce a desirable outcome?

What does this mean from a business perspective? That is, why should we care? Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare If we have an efficient outcome, there are no opportunities to create wealth. With inefficient outcomes, there are wealth creating opportunities.

From a business standpoint, an inefficiency offers an opportunity to create wealth by moving resources to higher value uses! This is done through voluntary transactions. My Value - $80,000 Consumer Surplus = $5,000 Suppose that you own a Porsche that you value at $65,000, but I value at $80,000 The sale of your car creates $15,000 of new wealth. The sale price determines how that wealth is allocated between us Sale Price = $75,000 Producer Surplus = $10,000 Your Value - $65,000

Again, think about efficiency as allocating resources to their highest value Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense VS. The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat) If you are the judge, who should prevail?

VS. • If Exxon Wins: • Exxon stockholders gain • Workers gain from added jobs • Motorists see falling gasoline prices • If Exxon Wins: • Sierra club members lay awake at night screaming $5M $10M A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

“A subtle but damaging factor in this is the dominance of economists at business schools. Although there is no evidence that economists are less ethical than members of other discipline, approaching the world through the dollar sign does make people more cynical”* AmitaiEtzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002

“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500 above its usual rate of $149”* Ethicist Joe Holt responds… “It is an act of moral abdication for businesses to pretend that they have no choice but to charge as much as they can based on supply and demand” * Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006

ALL voluntary transactions create wealth!! Value = $700/Night Consumer Surplus = $50 Consumer Surplus = $550 Price = $650 Either way, $600 of wealth is created! Producer Surplus = $550 Price = $150 Producer Surplus = $50 Cost = $100/Night

Cost = $100/Night Value = $800/Night Value = $1000/Night You have three rooms to rent. How do you set the price to create the most wealth? Value = $200/Night Cost = $100/Night Value = $600/Night Value = $400/Night Cost = $100/Night

CS = $400 Value = $1000/Night At a $600 per night price we create $2100 of wealth PS = $500 Cost = $100/Night CS = $200 Value = $800/Night CS = $600 PS = $1500 PS = $500 Cost = $100/Night Value = $600/Night CS = $500 Cost = $100/Night

CS = $850 Value = $1000/Night At a $150 per night price we could create $2100 of wealth PS = $50 Cost = $100/Night CS = $650 Value = $800/Night CS = $1950 PS = $150 PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 Cost = $100/Night

CS = $50 Value = $200/Night At a $150 per night price we could create $900 of wealth PS = $50 Cost = $100/Night CS = $250 Value = $400/Night CS = $750 PS = $150 PS = $50 Cost = $100/Night CS = $450 Value = $600/Night PS = $50 Cost = $100/Night

Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace "Greed captures the essence of the evolutionary spirit." -Gordon Gekko

What do we mean by a competitive market? #1: Many buyers and sellers – no individual buyer/firm has any real market power #2: Homogeneous products – no variation in product across firms #3: No barriers to entry – it’s costless for new firms to enter the marketplace #4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers #5: No Externalities –ALL costs/benefits of the product are absorbed by the consumer #6: Transactions are costless – buyers and sellers incur no costs in an exchange Can you think of situations where all these assumptions hold?

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day • You bought a boat for $1,000 • Maintenance on the boat is $50/Day • You pay $16/hour in labor costs • You pay $20/hour for fuel and other expenses What costs are fixed, sunk, and variable?

Lets try an example…suppose that you are a fisherman. To catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone A

Let’s try and picture this… Dollars Dollars AC TC VC = $.72*F $50 FC $.72 MC # of Fish # of Fish 0 0

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone B

Let’s try and picture this… TC Dollars Dollars VC =$266 + $1.20*F $266 FC $1.20 MC $50 AC $.88 # of Fish # of Fish 300 300

Lets try an example…suppose that you are a fisherman. Top catch larger quantities of fish, you have to go farther from shore and your catch per hour drops Zone A Zone B Zone C 50 Fish/hr 300 Max/Day 30 Fish/hr 300 Max/Day 20 Fish/hr 160 Max/Day Boat = $50 Labor = $16/hr Gas = $20/hr Lets take this section by section… Zone C

Let’s try and picture this… TC Dollars Dollars VC =$576 + $1.80*F $576 $50 FC $1.80 MC AC $1.04 # of Fish # of Fish 600 600

All together… Dollars Dollars TC Slope = 1.80 Slope = 1.20 MC $1.80 Slope = .72 ATC $50 FC $1.20 $.72 # of Fish # of Fish 0 300 600 0 300 600

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $1.20.

We are looking to maximize profits where profits are the difference between total revenues and total costs Dollars Dollars TC $94 TR $0 # of Fish $50 Slope = 1.80 Profit -$50 Slope = 1.20 Slope = .72 # of Fish 0 300 600 0 300 600 Marginal revenue is greater than marginal cost Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are increasing Profits are maximized Profits are decreasing

We could also go at this by looking at costs and benefits at the margin. For a perfectly competitive firm the market price equals marginal revenue.

Lets plot out marginal revenues and costs rather than total costs and revenues… Dollars Dollars $94 MC $1.80 $0 # of Fish MR $1.20 Profit -$50 $.72 0 300 600 0 300 600 Marginal revenue is greater than marginal cost Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are increasing Profits are maximized Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars MC $1.80 $1.20 MR $1.20 $.72 # of Fish 0 300 600 0 300 600 At a market price of $1.20, this firm will be willing to supply any quantity of fish between 300 and 600 At a market price of $1.20, MR = MC for any quantity of fish between 300 and 600

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $0.72.

All together… Dollars Dollars $0 # of Fish TC Slope = 1.80 -$50 Slope = 1.20 Slope = .72 TR $50 Profit # of Fish 0 300 600 0 300 600 Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are maximized Profits are decreasing

Perfectly competitive firms are “price takers”. They see a market price and can’t change it. Suppose that the market price is $.72.

All together… Dollars Dollars $0 -$50 MC $1.80 $1.20 $.72 MR Profit 0 300 600 0 300 600 Marginal revenue is equal to marginal cost Marginal revenue is less than marginal cost Profits are maximized Profits are decreasing

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars MC $1.80 $1.20 $1.20 $.72 MR $.72 # of Fish 0 300 600 0 300 600 At a market price of $.72, this firm will be willing to supply any quantity of fish between 0 and 300 At a market price of $.72, MR = MC for any quantity of fish between 0 and 300

When we talk about a supply curve we are talking about the profit maximizing decisions of individual firms at prevailing market prices Dollars Dollars $1.80 MC $1.80 MR $1.20 $1.20 $.72 $.72 # of Fish 0 300 600 0 300 600 At a market price of $1.80, this firm will be willing to supply any quantity of fish between 600 and 760 At a market price of $1.80, MR = MC for any quantity of fish between 600 and 760

What if the prevailing market was $1.35? Dollars Dollars MC $1.35 $1.35 MR # of Fish 0 300 600 0 300 600 At a market price of $1.35, this firm will be willing to supply exactly 600 fish. At a market price of $1.35, 600 fish are profitable to supply, but the 601st is not!

So we can get an individual firm’s supply curve by following marginal costs! Suppose that there are 1000 fishermen in the village – all with the same costs. Dollars Dollars $1.80 $1.80 $1.20 $1.20 $.72 $.72 # of Fish # of Fish 0 300 600 0 300,000 600,000 Individual Supply Market Supply Market supply adds up the decisions of each individual firm at each prevailing market price

So where do prices come from? We need to know how many fish people are actually willing to buy at any prevailing market price. Dollars $1.80 $1.20 $.72 # of Fish 0 150,000 500,000 900,000 A demand curve is just a record of how much the market collectively is willing to buy at any given market price

In equilibrium, total supply should equal total demand. If not, the price will adjust. Dollars Supply At a $1.80 price, fishermen will bring at least 600,000 fish to the market, but only 150,000 will get sold – the price needs to drop $1.80 $1.20 At a $.72 price, fishermen will bring at most 300,000 fish to the market, but 600,000 are demanded– the price needs to rise $.72 Demand # of Fish 0 300,000 600,000

In equilibrium, total supply should equal total demand Individual Market Dollars Dollars Supply $1.80 MC $1.80 $1.20 $1.20 MR $.72 $.72 Demand 0 300 600 0 300,000 600,000 500,000 The market determines the equilibrium price of $1.20 and 500,000 fish sold by the 1,000 fishermen At the prevailing market price of $1.20, each fisherman supplies between 300 and 600 fish

Boat = $50 Labor = $16/hr Gas = $20/hr A Few Diagnostics… Dollars Price= $1.20 - Gas Cost = $0.67 Labor’s Value Added= $0.53 * Labor Productivity = 30 Fish/Hr $16/hr = hourly wage MC $1.80 Producer Surplus = $144 $1.20 MR - Fixed Cost = $50 $144 Accounting Profit= $94 $.72 $94 *100 = 9.4% Return 0 300 600 $1,000 Is this fisherman earning economic profits?

Suppose that the excess returns causes 800 more fishermen (all with identical costs) to enter the market. Dollars Supply $1.80 $1.20 $.72 Demand # of Fish 0 300,000 600,000 540,000 1,080,000 1,368,000

In equilibrium, total supply should equal total demand Individual Market Dollars Dollars Supply $1.80 MC $1.80 $1.20 $1.00 $1.00 MR $.72 $.72 Demand 0 300 600 0 300,000 600,000 540,000 The market determines the equilibrium price of $1.00 and 540,000 fish sold by the 1,800 fishermen At the prevailing market price of $1.00, each fisherman supplies 300 fish

Boat = $50 Labor = $16/hr Gas = $20/hr A Few Diagnostics… Dollars Price= $1.00 - Gas Cost = $0.40 Labor’s Value Added= $0.60 * Labor Productivity = 50 Fish/Hr MC $30/hr > hourly wage $1.80 MR Producer Surplus = $84 $1.00 $84 - Fixed Cost = $50 $.72 Accounting Profit= $34 0 300 600 $34 *100 = 3.4% Return $1,000

Let’s see if we can’t generalize this a bit. We want marginal costs to be increasing – this reflects decreasing labor productivity at the margin TC Dollars Dollars MC $1.80 $1.20 $50 FC $.72 # of Fish 0 300 600 0 300 600

Economics of the Firm