Summary: Main Points on

Business Decisions and Supply

powerpoint slides for Chapter 11

selected answers from chapter 11

powerpoint slides for Chapter 12

selected answers from chapter 12

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Application of Rational Choice to Business Decisions

We have already learned that it is rational to do something until its marginal benefit equals its marginal cost.

Apply this to the business decision of choosing the quantity to produce and sell.

The benefit of selling a good equals the revenue from selling it -- so

• total benefit becomes total revenue
• marginal benefit becomes marginal revenue
• net benefit becomes profit

A rational producer chooses quantity supplied so that marginal revenue equals marginal cost.

If a producer does not shut down, its supply curve is its marginal cost curve.

In other words, the height of a good's supply curve shows the marginal cost of producing it.

Therefore the area under the supply curve shows the cost of producing a good, and the area above the supply curve but below the price shows profit (producer surplus).
 
 

Marginal cost and average cost

The Shut-Down Decision

The long run refers to a period of time over which people fully adjust their behavior to a change in conditions. Applied to a business firm, the long run is a period of time over which the firm can change the quantities of all its inputs. Chapter 11 discusses the long-run shut-down decision.

The short run refers to a period of time over which people cannot fully adjust to a change in conditions. Applied to business decisions, it refers to a period over which a firm cannot change the quantity of some input.

In the LONG RUN, a profit-maximizing firm stays in business if its total revenue covers its total cost.  Otherwise, it shuts down to avoid losing money.
Mathematically, in the long run a firm shuts down if TR < TC (or, in terms of average revenue and average cost, it shuts down if AR < AC).

To understand the SHORT RUN, you need to distinguish between variable costs and fixed costs.  Fixed inputs are inputs whose quantities a firm cannot change in the short run. Other inputs, whose quantities a firm can change in the short run, are variable inputs.  Fixed costs are costs of fixed inputs. Variable costs are costs of variable inputs.  In the long run, all inputs are variable.

In the SHORT RUN, a profit-maximizing firm stays in business if its total revenue exceeds its total variable cost (TVC).  Otherwise, it shuts down to avoid losing money.   Mathematically, in the long run a firm shuts down if TR < TVC (or, in terms of average revenue and average cost, it shuts down if AR < AVC).  If a firm's total revenue exceeds its total variable cost but not its total cost -- if TC > TR > TVC -- then the firm produces but earns a loss.

Why would a firm produce and earn a loss in the short run instead of shutting down? Because its loss would be even bigger if it shut down. The key point to understand is this: Variable costs are opportunity costs of producing. Fixed costs are not opportunity costs of producing, because a firm must pay fixed costs even if does not produce.  Fixed costs are unavoidable -- they are sunk costs. Therefore, only variable costs are relevant for the firm’s decision of whether or not to produce.  However, fixed costs affect calculations of profit.  A firm produces at a loss, in the short run, if it earns enough revenue to partly offset its fixed costs.
 

Measuring Costs and Profits

Accounting statements usually misstate a firm’s true opportunity costs and profit.

Accounting measures inaccurately state certain costs because they value inputs at historical costs rather than current opportunity costs.

Accounting measures also misstate total costs because they omit implicit costs, including the opportunity costs of the financial capital that owners have invested in the firm as well a their time, energy, creativity, and willingness to take risks.

Implicit costs also include opportunity costs of the firm’s trademark or brand name.

When accounting statements understate costs, they overstate profits—accounting profit exceeds economic profit.
 

DISCOUNTED PRESENT VALUE AND THE VALUE OF A FIRM

The discounted present value of a future amount of money is the money you would need to save and invest today to end up with a specific amount of money in the future.

The discounted present value of X dollars paid next year is X/(1 + i) dollars, where i is the interest rate, expressed as a decimal.

Repeated application of that formula leads to more complex discounted present value formulas.

The value of a firm is the discounted present value of its expected future profits. Economists often say a firm maximizes its profit instead of the more precise statment that a firm maximizes its value.