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A Simple Model of the Firm 31

between actions and the ultimate objective, namely, profit. It remains for the

firm’s manager to “solve” and explore this decision problem using marginal

analysis (steps 5 and 6).

Before turning to this task, note the simplifying facts embodied in state-

ment 1. Typically, a given firm produces a variety of goods or services.

Nonetheless, even for the multiproduct firm, examining products one at a time

has significant decision advantages. For one thing, it constitutes an efficient

managerial division of labor. Thus, multiproduct firms, such as Procter &

Gamble, assign product managers to specific consumer products. A product

manager is responsible for charting the future of the brand (pricing, advertis-

ing, promotion, and production policies). Similarly, most large companies

make profit-maximizing decisions along product lines. This product-by-product

strategy is feasible and appropriate as long as the revenues and costs of the

firm’s products are independent of one another. (As we shall see in Chapters 3

and 6, things become more complicated if actions taken with respect to one

product affect the revenues or costs, or both, of the firm’s other products.) In

short, the firm can maximize its total profit by separately maximizing the profit

derived from each of its product lines.

A Microchip Manufacturer

As a motivating example, let’s consider a firm that produces and sells a highly

sophisticated microchip. The firm’s main problem is to determine the quantity

of chips to produce and sell (now and in the immediate future) and the price.

To tackle this problem, we begin by examining the manager’s basic objective:

profit. A simple accounting identity states that profit is the difference between

revenue and cost. In algebraic terms, we have R C, where the Greek let-

ter pi () stands for profit. To see how profit depends on the firm’s price and

output decisions, let’s examine the revenue and cost components in turn.

REVENUE The analysis of revenue rests on the most basic empirical rela-

tionship in economics: the law of demand. This law states:

All other factors held constant, the higher the unit price of a good, the fewer the

number of units demanded by consumers and, consequently, sold by firms.

The law of demand operates at several levels. Consider the microchip indus-

try as a whole, consisting of the manufacturer in question and a half-dozen

major competitors. Suppose the leading firms raise their chip prices due to the

increased cost of silicon. According to the law of demand, the industry’s total

sales of chips will fall. Of course, the law applies equally to a single chip manu-

facturer. An individual firm competes directly or indirectly with the other lead-

ing suppliers selling similar chips. Let’s suppose that currently there is a stable

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