12.7 Conclusion: Lessons from the model

We began this chapter by exploring how your brewery makes profits. In determining what price to charge and how much to produce, your decisions are constrained by buyers’ willingness to pay.

At the same time, costs play a crucial role in pricing and production decisions. You can’t give away your beer for free because you need to cover expenses such as worker wages, utility bills, and ingredient costs. Additionally, opportunity costs must be considered, because they help you understand what you are forgoing.

Our thought exercises led you to think incrementally, guiding you through the decision of whether to produce one more keg by comparing marginal revenue (MR) to marginal costs (MC). By setting MR = MC, you aimed to maximize profits. However, you might be wondering: Do all firms set price and quantity by equating MR and MC? The answer is no. Firms, including breweries, must first learn about their demand curve. In other words, they need to understand what buyers are willing to pay. Additionally, brewers must assess all opportunity costs, which can make it difficult to accurately determine total production costs.

Moreover, not all brewers prioritize profit maximization:

  • Some may focus more on revenue or personal satisfaction as entrepreneurs.
  • Others may aim for profitability but choose not to set high price markups, even if buyers are willing to pay more.

Everyday Economics 12.11

Do you run your own business? Do you have a family member or friend who runs their own business? If you do, ask them if they set MR = MC. Economist Steven Levitt analyzed 13 years of data from a company, run by an economist, that delivers donuts and bagels to businesses in the Washington, DC area. Levitt found that the company sets its price where marginal revenue is negative, suggesting that the company is setting the price too low and lowering its profits by 30%. You can find the article here.

In reality, most brewers experiment with pricing and production to find the right balance. Through trial and error, they determine the price–output combination that aligns with their profit goals and commitments. Based on our analysis, CORE Brewing’s profit-maximizing price and production is likely \(P = $240\) and \(Q = 4\), as shown in Figure 12.8.

In the next chapter, we explore why firms care about buyers’ responsiveness to price changes when setting marginal revenue equal to marginal costs. We also explore the other decisions firms make, such as how much to spend on advertising and how to engage with firms offering similar products.

Skill and learning objectives

  1. Constructing a table of data and identifying trends in the data
  2. Graphically illustrating data and analyzing shapes of curves
  3. Applying the marginal cost equals marginal benefit rule to a firm
  4. Defining important economic terms
  5. Modeling a firm’s decision on what price to charge and how much to produce in order to maximize profits
  6. Thinking at the margin
  7. Constructing and interpreting heat maps to illustrate a firm’s decision-making process
  8. Understanding opportunity costs for a firm.

Concepts to be learned

  1. Total revenue and marginal revenue
  2. Total costs, marginal costs, average costs
  3. Economic profits
  4. Economies of scale
  5. Opportunity costs
  6. Willingness to pay
  7. Demand
  8. Price markup
  9. Differentiated products.

Seeing the Principles in Action

Principle Example Everyday economics
Interdependence principle Economic outcomes depend on strategic choices people make in different parts of the economy. The decisions firms make are influenced by several other players, such as buyers, workers, other producers, and the government. If you ran your own business, how would subsidies for firms that promote energy-efficient technology impact your business? How would tariffs imposed by other countries impact your business? How would buyers who want to boycott your product impact your business?
Doing the best you can principle People make choices that will result in the best outcome for them given what they anticipate others will do in response—like firms trying to earn as much profit as possible given that they face constraints such as demand for their product by buyers. If you ran your own business, why would it be important for you to pay attention to what buyers want and what they are willing to pay for your product? Why would it be important for you to pay attention to what other businesses in the industry produce and how they price their product?
Rules of the game principle The rules of the game—institutions—govern what people can and cannot do, such as when some firms can get easy access to credit to expand their firms and other firms face significant barriers to gaining access to credit. Or how some firms have to obtain a license or permit to sell their product. Or how certain laws protect buyers or buyers’ data. The principle can also be applied to large firms since firm size can be a strategic advantage, shaping the distribution of economic benefits. For example, larger firms receive discounts because the current rules suggest that firm size governs supplier relationships. If you ran your own business, what rules of the game would you need to follow? In what ways do these rules limit what you can and cannot do? As a buyer, what rules of the game do you need to follow? How would right-to-repair laws impact firms and buyers?
Trade-offs and opportunity costs principle People evaluate what they do in comparison to their outside option or next best alternative, which captures the opportunity cost of one action compared to another, such as when firms understand that to sell more units of their product, they may need to lower the price, giving up higher revenue on those units in exchange for higher output and sales. Or when firms decide to spend more money on energy-efficient technology such as solar panels, they forgo spending more money on advertising. What is your next best alternative to running a business? What else could you do with your time or money?
Principle of gains from cooperation and conflict of interest Cooperation can lead to greater benefits for everyone, but also to competition and conflict over the benefits. Cooperation can lead to buyers and sellers benefiting, but also to conflict over what prices products should be sold at. As a buyer, how do you benefit from firms producing and selling goods that you like or need? How does the firm benefit? Do you each benefit equally?
Principle of individual and societal interests When people do the best they can, they may make choices that do not lead to the best outcomes for everyone or for the environment, such as when firms produce their products in ways that have a negative impact on the environment or when they charge prices that are so high that some buyers can’t afford to purchase them. Have you seen situations in the news where firms’ production processes are damaging the environment because they are trying to maximize profits? Have you seen situations in the news where firms’ choices have a negative impact for buyers or workers because they are trying to make as much profit as possible?

References

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