Theory of the Firm Notes:

Production and Costs:

- Distinguish between the short run and long run in the context of production:

Short-Run: the period of time when at least one factor of production is fixed.

Long-Run: the period of time when all factors of production are variables.

- Define total product, average product and marginal product, and construct diagrams to
show their relationship:

Total product: is the total number of units produced

Average Product: is the number of units produced per worker

Total product

------------------

Q of labour

Marginal Product: is the change in total output brought about by the last worker

Change in TP

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Change in Q of labour
 - Explain the law of diminishing returns:

Law of diminishing returns: is, as more and more units of a variable input are added to one or more
fixed inputs, the marginal product of the variable input as first increases, but there comes a point
when it begins to decrease.

Costs of Production: economic costs:

- Explain the meaning of economic costs as the opportunity cost of all resources employed
by the firm (including entrepreneurship):

In economics, an economic cost of production is defined as the opportunity cost of all the resources
employed by the firm. Economic cost has two main components, explicit and implicit costs.

- Distinguish between explicit costs and implicit costs as the two components of economic
costs:

Explicit Costs: this refers to the opportunity cost of factors not already owned by the firm. These
costs are simply expressed as the price that a firm must pay for an item such as raw materials or
water. Examples are rent, wages, raw materials.

Implicit Costs: when a firm already owns a factor of production, they don’t have to pay money for
their use, but an opportunity cost exists. In this instance, the opportunity cost is what firms could
have earned from hiring out the use of the factor to another firm instead of using it.

Costs of Production in the Short-Run:

- Explain the distinction between the short run and the long run, with reference to fixed
factors and variable factors:

In the short-run, some factors of production are fixed in supply, however in the long-run there are
no factors of production that are fixed.

Short-Run:

Fixed Variable
- Marketing - Fabric
- Admin - Electric parts
- Staff wages - Packaging
- Transport
- Overheads
- Rent

- Distinguish between total costs, marginal costs and average costs:

Total Costs: is the sum of variable costs and fixed costs

TC=TFC+TVC
Average Cost: is the cost per unit to produce

ATC = TC

----

Marginal Cost: is the additional cost of producing one more unit

MC= change in TC

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Change in Q

- Draw diagrams illustrating the relationship between marginal costs and average costs, and
explain the connection with production in the short run:

Relationship of MC and AC:

MC=AVC at AVC lowest point if mc is

bigger than avc then avc increases, if
mc is smaller than avc then avc will
decrease. They are short run costs.
 - Explain the relationship between the product curves and the cost curves, with reference to
the law of diminishing returns:

Relationship of MP and MC:

As MP increases then MC decreases, this is because as workers start to be more productive it costs
less to produce once diminishing marginal returns start MC increase as it costs more when workers
become less productive.

- Calculate total fixed costs, total variable costs, total costs, average fixed costs, average
variable costs, average total costs and marginal costs from a set of data and/or diagram:

Total fixed costs = adding all the fixed costs together

Total variable costs = number of workers * wage

Total costs = TFC + TVC

Average fixed costs = TFC / quantity

Average variable costs = TVC / output

Average total costs = TC / quantity

Marginal costs = change in TC / change in quantity

Production in the long run: returns to scale:

- Distinguish between increasing returns to scale decreasing returns to scale and constant
returns to scale:

Increasing Returns to Scale: a given % increases in input leads to a greater % increase in output

Decreasing Returns to Scale: a given % increase in input leads to a lesser % increase in output

Constant Returns to Scale: % increase in input leads to a % increase in output

Costs of production in the long run:

- Outline the relationship between short-run average costs and long-run average costs:

In the short-run at least one factor of production is fixed, however, in the long-run none of the
factors of production are fixed and all of them
are variable.

The LRATC is made up of a series of SRAC curves

If a firm is operating at point A the firm can

expand (increase fixed FOP) in order to decrease
AC (point C)

SRAC shifts when firms buy new machinery

 - Explain, using a diagram, the reason for the shape of the long-run average total cost:

The reason for the LRATC curve is shaped like that is because the decreasing section of it is
economies of scale and the increasing part is the
diseconomies of scale part.

- Describe factors giving rise to economies of scale, including specialization, efficiency,

marketing and indivisibilities:

These following examples can lead to rise of economies of scale:

Example: Explanation:
Technical A larger firm may be able to adopt technology
of production not available to smaller firms
- e.g. assembly line
Financial A large firm can borrow money from a bank at a
lower interest rate.
Managerial A larger firm can employ specialist
- e.g. accountant
Marketing Input = bulk buying
Output= decrease in distribution cost
Risk-bearing A larger firm can diversify, decreasing the risk
of the firm.

- Describe factors giving rise to diseconomies of scale, including problems of coordination

and communication:

Examples of a rise of diseconomies of scale:

Example: Explanation:
Coordination If parts are missing (slows down production) or
too many ordered, storage problems.
Communication: Take too long/longer to communicate between
departments.

Revenues:

Total revenue, average revenue and marginal revenue:

 - Distinguish between total revenue, average revenue and marginal revenue:

Total Revenue:

TR = P * Q

Average Revenue: revenue per unit sold (=P)

AR = TR / Q

Marginal Revenue: additional revenue arising from the sale of one additional unit

MR = change in TR / change in Q
 - Draw diagrams illustrating the relationship between total revenue, average revenue and
marginal revenue:

- the marginal revenue curve is twice as steep as the AR curve.

- Revenue is maximised, on the TR curve, when MR = 0
- When AR is bigger than MR = 0 the demand is elastic.
- When AR is equal to MR = 0 the demand is unit elastic
- When AR is smaller than MR = 0 the demand is inelastic

Calculate PED:

PED = % change in quantity / % change in price

Profit:

Economic profit:

- Describe economics profit as the case where total revenue exceeds economic cost:

Abnormal Profit: total revenue exceeds total costs

 - Describe normal profit as the case where total revenue is equal to total costs or the
situation in which the amount of revenue earned is just enough to keep the firm in its
current line of business:

Normal Profit: total revenue equals to total costs

- Explain that economic profit is profit over and above normal profit and that the firm earns
normal profit when economic profit is zero
- Explain why a firm will continue to operate even when it earns zero economic profit:

Normal profit includes the opportunity cost of factors of production

Does not = accounting profit = 0

- Calculate different profit levels from a set of data and/or diagrams:

To calculate profit = TR – TC, if the profit is above zero, then it is abnormal. If it is at zero, then it is
normal. If it is below zero it is a loss.

Goals of firms:

Profit maximization:

- Explain the goal of profit maximization where the difference between total revenue and
total costs is maximised or where marginal revenue equals marginal costs:

Profit maximization: is the point where total cost is smaller than total revenue by the biggest
margin.

- MC = MR

Alternative Goals of firms:

- Describe alternative goals of firms, including revenue maximization, growth maximization,

satisficing and corporate responsibility:

Alternative goal: Explanation: Why would a firm have this

goal?:
Revenue Maximization Increasing number of units - Linked to bonuses
sold to increase revenue - Motivate employees
Growth Maximization Focus on growth of the firm - Economies of scale
- diversify
Satisficing Rather than maximizing one - most likely do not
variable try to do all by not want to forfeit
maximizing one growth for revenue
etc.
Corporate Social Impact on the environment - brand image
Responsibility and society
Perfect Competition:

Assumptions of the model:

- describe, using examples, the assumed characteristics of perfect competition:

The characteristics are:

- large number of firms

- a homogeneous product
- freedom of entry and exit
- perfect information
- perfect resource mobility

Revenue Curves:

- Explain, using diagram, the shape of the perfectly competitive firm’s average revenue and
marginal revenue curves, indicating that the assumptions of perfect competition imply
that each firm is a price taker:

These diagrams show that all firms are price takers, since the market is the one to set the price,
and the firms take those prices as if they decrease or increase it the effect will not be good for
them. The only way of changing these prices is in supply or demand change.

Profit maximization in the short-run:

- Explain, using diagrams, that it is possible for a perfectly competitive firm to make
abnormal profit, normal profit or negative profit in the short run based on MC and MR
profit maximization rule:
This is abnormal profit in the short run as AC is lower than P
Profit maximization in the long-run:

- Explain, using a diagram, why, in the long run, a perfectly competitive firm will make
normal profit:

Firms are attracted by the abnormal profit so they join the market causing supply to increase and
therefor decreasing the price to AC making it normal profit