Theory of the Firm
Definitions:
Firm: Organization or enterprise formed by entrepreneurs who bring together factors of production –
land, labour, and capital, to produce goods or services for sale
Industry: comprises a group of firms that produce a single good or service, or a group of related
goods or services.
Production Function: f(land, labour, capital, entrepreneurship)
Explicit Costs: costs which involve a direct payment to outside suppliers of inputs
Implicit Costs: costs which do not involve a direct payment of money to a third party, but which
nevertheless involve a sacrifice of some alternative
Total Economic Cost = Explicit Cost + Implicit Cost
Profit = Total Revenue – Total Cost
Short Run: a period of time where there is at least one fixed factor of production
Long Run: a period of time where there are no fixed factors of production
Fixed Factor: a factor of production that cannot be increased in the short run.
Variable Factor: a factor of production that can be increased in the short run.
Normal Profit: the minimum level of reward required to ensure that existing entrepreneurs are
prepared to remain in their present area of production
Economies of Scale: when the expansion of a firm or industry allows the product to be produced at a
lower unit cost.
The Short Run
In the short run, there exists a law of Diminishing Returns, but only in the Short Run. “
if increasing quantities of a variable factor are applied to given quantity of a fixed factor, the
marginal product (MP) and the average product (AP of the variable factor will eventually decrease
Assumptions:
1. All factors are fixed except for the given variable factor
2. Technology is given
3. Units of variable factor are homogenous
If TR>TC – firm makes super normal profits (SNP), and is likely to expand
If TR=TC – firm makes normal profit (NP), and should stay in business
if TR<TC – firm makes loss, and should close in the long run.
Fixed Costs: also known as indirect or overhead costs, as output increases FC is spread over more
units so Average Fixed Cost (AFC) is a rectangular hyperbola.
Variable Costs: also known as prime or direct costs, as output increases TVC rises at differing rates,
but AVC is generally U-shaped, falling as efficiency improves then rising as efficiency declines. The
lowest point on AVC is the shut down point. In the SR firms should ignore FCs entirely as they are
sunk costs, hence loss making firm can more than cover its variable cost then it should keep going in
the SR as surplus above VCs will go some way to covering FCs.
Total Costs: Fixed Costs + Variable Costs, Average Total Cost (ATC) is also U-shaped, the lowest point
is the technical optimum whereby it is the most efficient output.
Marginal Cost: is the additional cost of producing one more unit of output, is purely a function of
variable costs, and cuts the AVC and ATC at their lowest points.
The Long Run
Returns to scale exist in the Long Run, whenever you see the word “scale”, it suggests that firms are
able to change all factors of production
Returns to Scale:
%increase in outputs > %increase in inputs: increasing returns to scale
%increase in outputs = %increase in inputs: constant returns to scale
%increase in outputs < %increase in inputs: decreasing returns to scale
Economies of Scale
1. As the firm expands - Internal Economies of Scale
2. As the industry which the firm expands – External Economies of Scale
Internal Economies of Scale
Some EOS arise due to increasing returns to scale, others do not (has to do with direct relationship
between inputs and outputs)
1. Physical/Technical – advantages to producing on a larger scale
a. Division of Labour, more efficient (production line)
b. Capital equipment is used more efficiently (indivisibility)
i. Container principle, all storage is more efficient on a larger scale
c. Minimum Efficient Scale (MES)
2. Managerial – can employ more specialist managers which should improve efficiency (division
of labour at a managerial level)
3. Commercial
a. Cheaper to BUY in bulk
b. Large firms can dictate customers and employ more expensive sophisticated ad
campaigns
4. Financial
a. Firms can plough back profits for expansion
b. Can borrow at more favourable rates
c. Can sell their shares more cheaply and more easily, so greater access to finance
5. Risk Bearing – larger firms are better able to survive setbacks
Economies of Scope: applies to firms that produce a range of products, sharing transport and
distribution facilities.
Diseconomies of Scale:
1. Management Problems – too much red tape and bureaucracy, decision making is slow
2. Workers feel alienated – too impersonal
3. Industrial relations sour – leading to strikes etc
4. Loss of personal touch with customers.
External Economies of Scale:
Advantages enjoyed by a firm within an industry when the whole industry expands
1.
2.
3.
4.
5.
Skilled labour becomes more readily available as it is concentrated in a location
Shared facilities for R and D, sharing costs and logistics
Ancillary trades spring up: delivery, advertisements and upkeep, lower delivery costs
Trade Associations may be set up, running training courses, etc
Reputation (and associated reputation)
Cost of Production in the LR
In the LR all factors are variable so there are no fixed costs. LRAC curve is constructed as a envelope
curve, drawn tangentially to a whole family of SRAC curves.
Increasing returns to Scale – LRAC is falling
Constant returns to scale – LRAC is constant from MES onward, over this range of output firms can
operate at a maximum efficiency
Decreasing returns to scale – LRAC is rising
Firm may be experiencing diminishing returns in the SR, but experiencing increasing returns in the
Long Run, typical of young firms (sunrise industries) as they expand
Firm may experience increasing returns in the SR while decreasing returns to scale in the LR. Has
spare capacity but would be better reducing the scale of operation, typical of declining (sunset)
industries.
LRAC falls over any range of output – natural monopolies
Growth of Firms
Size of labour force, value of sales, value of capital and share of market
1. Achieve EOS
2. Achieve more market (monopoly) power
3. Achieve stability (risk bearing or diversifying)
Firms can have internal or external growth. External growth is when they take over or merge with
other firms.
1. Horizontal integration – joining with firms that do similar things, EOS and market domination
2. Vertical integration – joining with firms at another stage of production, ensures steady flow
of materials to markets but few EOS
3. Conglomerates – joining with quite different firms, diversifying, economies of scope.
Survival of Small Firms
Dominate markets which provide personal services e.g. tailoring, where goods are perishable and
where markets are very localized. Or markets where firms have few EOS, like services.
Small firms co-exist with large firms because LRAC is flat over a large range of output. Some firms
remain small out of choice – e.g. family businesses. Small firms are more flexible and more
innovative than larger firms and “fill in the gaps”
Revenue
Total Revenue = Price x Quantity
Average Revenue = Total Revenue/Quantity = Price
Marginal Revenue = Change in Total revenue/Change in Quantity.
Price Taker – Perfectly Horizontal/Perfectly Elastic AR, Demand
Price Maker – Downward sloping demand curve, imperfect competition
Profit Maximization
Assumed that firms aim to maximize profits, hence
maximize the gap between TR and TC, this always
occurs where MR = MC with MC rising, and applies to
both price takers and price makers.
At any output below Q* profits could be increased by
increasing sales
At any output beyond Q* profits could be increased by
reducing output.
Exceptions:
1. Firms do not have the information/data to maximize profits, opp. cost of spending money to
acquire that information does not justify spending the money. Profit maximization can occur
in the short run, long run, risk averse or risk taking. Firms operate in a dynamic environment
but our analysis is a static once, basically, ceteris not paribus. “near enough is good enough”.
2. Managerial Capitalism – divorce between ownership and management, principal agent
problem where managers may have a motivation different from the owners. Agents know
more about the situation than principals (asymmetric information). Agents maximize their
own utility. Profit-sharing and bonuses are supposed to help
3. Behavioural Theories – Satisficing: firms have a number of targets such as profit, sales,
market share and output, and priority may be given to different targets at different points in
time, so there is no unique equilibrium for the firm
4. Unrealistic assumption or predictive power of a theory?