Theory of the firm I

Production and costs

Production in the short run: Law of diminishing returns.

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

The short run is a time period during which at least one input is fixed and
cannot be changed by the firms.
The long run is a time period when all inputs can be changed.

Define total product, average product and marginal product,

and construct diagrams to show their relationship

Total product (TP)

The total quantity of

output produced by a
firm
Marginal product
The extra or additional
(MP)
output resulting from
TP
one additional unit of
MP=
units of labour
variable input, labour; it
tells us by how much
output increases as
labour increases by one
worker.
Average product (AP) The total quantity of
TP
output per unit of
AP=
units of labour
variable input, or labour;
this tell us how much
output each unit of
labour produces on
average.
* You should be able to calculate total, average and marginal products from a
set of data and/or diagrams
A graph showing the relationship between TP, MP and
AP.


the

Explain
law of

diminishing returns
According to the law of diminishing returns, as more and more units of
variable input are added ton one or more fixed inputs, the marginal
product of the variable input first increases, but then comes a point when
it begins to decrease. This relationship presupposes that the fixed inputs
remain fixed, and that the technology of production is also fixed.

Costs of production: economic costs

Explain the meaning of economic costs as the opportunity cost

of all resource employed by the firms

Economic costs are the sum of explicit and implicit costs, or total
opportunity costs incurred a firm for its use of resources, whether purchased
or self-owned. When economists refers to costs they mean economic costs

Distinguish between explicit costs and implicit costs as the two

components of economic costs

Explicit costs are payment made by a firm to outside to acquire resources

for use in production.
Implicit costs are the sacrificed income arising from the use of self-owned
resources by a firm.

Costs of production in the short run

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

Fixed costs arise from the use of fixed inputs, they are costs that do not
change as output changes this include rental payment, property taxes
and interest on loans. Even when there is 0 output these costs will stay
the same
Variable costs arise from the use of variable goods, these costs vary as
output increases or decreases. This includes the wage of labour, in order
to increase the output the employee needs to hire more workers causing
variable costs to increase.
In the short run, a firms total costs are the sum of fixed and variable
costs, yet in the long run as there are no fixed costs the total costs is
equal to the variable costs.

Distinguish between total costs, marginal costs and average

costs

Average costs

Marginal costs

Total costs per unit of

output, or total cost
divided by the number
of units of output.
The extra or additional
costs of producing on
more unit.

ATC = AFC+AVC

MC=

TC TVC
=
Q
Q

Costs of production in the short run

Explain the distinction between the short run and long run,
with reference to fixed factors and variable factors.
In the short run, at least one variable is fixed. In the long run, all
factors are variable except the state of technology.

Distinguish between total costs, marginal costs and average

costs.
Total costs are the sums of fixed (total costs of all fixed assets that a
firm uses in a given time) and variable costs (total costs of all variable
assets a firm uses in a given time). Marginal costs are the costs of
producing one extra unit of output. Average costs are the costs per unit
output.

Draw diagram illustrating the relationship between marginal

costs and average costs, and explain the connection with
production in the short run.
The marginal cost has to intersect the average cost
at its lowest point. While the marginal cost is below
the average cost, the average cost will continue to
decrease. When the marginal cost increases above
the average cost, however, average cost too will
increase, so that is why marginal cost equals
average cost at its lowest point.

Explain the relationship between the product curves and the

cost curves with reference to the law of diminishing returns.

(See diagram above) To start with, as output increases average cost decreases as does
marginal output. After a point, however, due to diminishing marginal returns, both the
marginal and average cost increases.

(See diagram left) Similarly, due to diminishing

returns, after a point, increasing the input will
only cause output per unit input to decrease
instead of rising. This will cause marginal product
to drop. However, it is only when marginal
product is less that average product that average
product will also start to drop. Hence, the
marginal product intersects the average product
at its highest point.

*NOTE: You must be able to 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 diagrams.

Production in the long run: returns to scale

Distinguish between increasing returns to scale, decreasing
returns to scale and constant returns to scale.
In the long run, as output per period
increases, cost per unit output
decreases due to economies of scale
(e.g. benefits of specialization). As a
result of the decrease in average cost,
there are increasing returns to scale.
However, due to diminishing returns,
after a certain point cost per unit output
does not decrease but remains the same
and there are constant returns to scale.
If output per period continues to
increase there can be decreasing returns
to scale due to diseconomies of scale
(e.g. strained control and communication).

Cost of production in the long run

Outline the relationship between short-run average costs and
long-run average costs
The LRAC (Long Run Average
Cost) curve is U-shaped because
of economies and diseconomies
of scale.

The SRAC (Short

Run Average Cost)
curve is U-shaped due
to the law of
diminishing returns.

In the short run (the

production stage)
costs increase as
output increases because at least one fixed factor of production
restrains further growth.
In the long run (the planning stage) all factors of production are
variable, apart from technology, so production can move to a new
short-term curve. Once production begins the firm is again stuck on the
new short-term curve. In the next wave of planning, however, the firm
can again increase all factors, apart from technology, and move to a
new point on the LRAC curve.

Explain, using a diagram, the reason for the shape of the long
run average total cost curve
Economies of scale will experience
increasing returns to scale until a
certain point, this means that
when input doubles, and its input
price are constant, its output will
be increasing more than double. At
the constant returns to scale the
input equals the output, yet at a
certain point output is less than
inputs at this point the firm
engages in diseconomies of scale.

Describe factors giving rise to economies of scale, including

specialization, efficiency, marketing, and indivisibilities.
Specialization of labor When the scale of production increases more workers must
be employed allowing for greater specialization, each worker can perform tasks that
use their full potential, thus allowing for a greater efficiency and allowing output to
be produced at a lower average costs.
Specialization of management When scale of production is increased each
manager can be specialized in a particular area, again allowing greater efficiency.
Efficiency of capital equipment Large machines are sometimes more efficient
than smaller ones, these can only be used by economies of scale as a small firm
would not be able to use a large machine to its full potential
Indivisibilities of capital equipment Some machines are only available in a large
size and therefor are not available for small firms
Indivisibles of efficient processes Production processes such as mass assembly
lines require large output, and can therefor only be used by large firms
Spreading of certain costs, such as marketing, over larger volumes of output
Costs of advertising, design, research and development result in lower average
costs if the can be spread over large volumes of output.
Bulk buying:
As firms increase in scale they are often able to negotiate discounts with suppliers
that they would not have received when they were smaller, the cost of their inputs is
then reduced, which in turn reduces the costs of production.
Financial economies:
Large firms can raise financial capital more cheaply because banks tend to charge
lower interest rates to larger firms, since the larger firms are considered to be less
of a risk than the smaller firms, and are less likely to fail to repay their loans.
Transport economies:
Large firms making bulk orders may be charged less for delivery costs than smaller
firms. Also, as firms grow they may be able to have their own vehicles, which will
cost less because of not having to pay other firms, who will include a profit margin.

Describe factors giving rise to diseconomies of scale, including

problems of communication and coordination.
Coordination and monitoring difficulties When a firms grow and grow it becomes
harder to fully coordinate and monitor everything, which leads to inefficiencies in
production
Communication difficulties A larger firm might have problems communicating
between various components of productions.
Poor worker motivation A worker who is not motivated will become less efficient

Revenues

Total revenue, average revenue and marginal revenue

Distinguish between total revenue, average revenue and
marginal revenue
Total revenue (TR)

Marginal revenue
(MR)

Average revenue
(AR)

The total revenue

arising from payments
firms receive when
they sell the goods and
services
The additional revenue
arising from the scale
of an additional unit of
output
Revenue per unit sold

TR=P Q

MR=

AR=

TR
Q

TR
Q

Illustrate, using diagrams, the relationship between total

revenue, average revenue and marginal revenue.

As previously states, AR is equal to price and so it falls as output increases,

since the price has to be lowered in order to sell more products. This is
shown in the diagram above where the demand curve is labeled as AR. MR
also falls as output increases but twice as steeply as AR and also goes below
the x-axis. This relationship holds for all downward sloping AR curves and the
MR curves relating to them. MR is below AR because in order to sell more
products the firm has to lower the price of the products being sold losing

revenue on the ones that could have been sold at a higher price in order to
get the revenue from the extra sales. For TR, extra units are being sold so TR
rises; however, in order to do this the price has to be lowered. As a result, for
a normal downward sloping demand curve TR rises at first but eventually
starts to fall due to lowered prices.

Profit
Economic profit and normal profit

Describe economic profit as the case where total revenue

exceeds economic costs.

Economics profit = total revenue economic costs

Describe normal profit as the case where total revenue is equal
to total economic costs or the situation in which the amount of
revenue earned is just sufficient to keep the firms its current
line of business.
Normal economic profit can be defined as the minimum amount of
revenue that the firm must receive so that it will keep the business
running. It is when economic profit is equal is zero, so that it covers all
implicit costs.

Explain why a firm will continue to operate even when it earns

zero economic profit.
A firm will continue to operate because it may able to cover its average
variable costs. This is the most important because if it cannot cover
these costs in the short run, it will have to shut down in the short run.

Explain the difference revenues

Normal profit is when the firms manages to covers its production costs
Abnormal profit or supernormal profit is when a firms revenue
exceeds its production costs
Negative profit is when a firms profit is less than its production costs

Goals of firms
Profit maximization

Explain the goal of profit maximization where the difference

between total revenue and total cost is maximized or where
marginal revenue equals marginal cost
The goal of profit maximization is where the difference between total
revenue and total cost is maximized or where marginal revenue equals
marginal cost, and is given by the formula Total revenue total cost.

Alternative goals of firms

Describe alternative goals of firms, including revenue
maximization, growth maximization, satisficing and corporate
social responsibility
- Revenue maximization
Increasing sales and maximizing revenues may be more useful to a firm
than profit maximization for the following reasons:
o Sales can be identified and measured more easily over the short run,
increased sale targets can be used to motivated employees
o Rewards for managers and employees are often linked to increase
sales
o It is often assumed that revenue from more sales will increase more
rapidly than costs.
o Increased sale give rise to a feeling of success
- Growth maximization
It is sometimes assumed that firms will be more interested in maximizing
growth rather than economic profit for the following reasons
o A growing firm can achieve economies of scale lowering average
costs
o As a firms growth it can diversify into production of different product
and market and reduce its dependence on a single product
o A larger firm has greater market power and increased ability to
influence prices
o A larger firm might be less affected by economic downturns
- Managerial utility maximization
- Satisficing

When firms work hard enough to cover the opportunity costs, so to a

satisfactory level, rather than maximization. This allows them to pursue
other goals. In general people who do not actually own these firms run
them (e.g. shareholders who are not involved in running the company and
are therefore managed by employed non-owners).
- Corporate Social Responsibility
is where a business includes the public interest in its decision making. It
adopts an ethical code that accepts responsibility for the impact of its
activities on areas such as the workforce, consumers, the local community
and the environment.