31.3 Theory of the Firm (HL ONLY) Part I
Sub-topic
Production and costs
Production in
the short run:
the law of
diminishing
returns
HL Core – Assessment Objectives
AO2 – Distinguish between the short run and long run in the context of production.
Long run is the planning stage; short run is in the production stage.
AO1 – Define total product, average product and marginal product, and construct diagrams to show their
relationship.
Total Product: is the total output that a firm produces, using its fixed and variable factors in a given time
period.
Average product is the output that is produced, on average, by each unit of the variable factor.
Marginal product is the extra output that is produced by using an extra unit of the variable factor.
AO3 – Explain the law of diminishing returns.
In economics, diminishing returns (also called diminishing marginal returns) is the decrease
in the marginal (per-unit) output of a production process as the amount of a single factor of
production is increased, while the amounts of all other factors of production stay constant.
For example, a man starts a business, where he works alone. He can make 20 burgers an hour,
having his fixed factors (Grill, countertops for preparing burgers and a small shop) but does
not have to pay any workers. Now as demand is higher, he has to higher one worker, raising
the burgers per hour to 50. Once he then has too many workers, lets say 5, they are going to
just be a negative impact due to the payment he has to give them and the efficiency of the
workers goes down, as they are just in each others ways. *NOTE: You must be able to calculate
Costs of
production:
economic
costs
Costs of
production in
the short run
total, average and marginal product from a set of data and/or diagrams.
Economic costs are the opportunity cost of all resources employed by the firm (including entrepreneurship).
AO2 – Distinguish between explicit costs and implicit costs as the two components of economic costs.
Explicit cost is a business expense accounted cost that can be easily identified such as wage,
rent and materials.
An implicit cost results if the person who at first foregoes the satisfaction in the search of an
activity and is not rewarded by money or another form of payment.
AO3 – Explain the distinction between the short run and the long run, with reference to fixed factors and
variable factors. Microeconomics, the long run is the conceptual time period in which there are
no fixed factors of production as to changing the output level by changing the capital stock or
by entering or leaving an industry. The long run contrasts with the short run, in which some
factors are variable and others are fixed, constraining entry or exit from an industry. In
macroeconomics, the long run is the period when the general price level, contractual wage
rates, and expectations adjust fully to the state of the economy, in contrast to the short run
when these variables may not fully adjust.
In the short run, at least one variable is fixed. In the long run, all factors are variable except the state of
technology.
AO2 – Distinguish between total costs, marginal costs and average costs.
The total cost is what the name suggests, the whole amount of cost that the production takes.
The average cost is the total cost of production of x units of the product divided by x.
Marginal cost refers to the additional amount required to produce the x+1th unit. This does
not have to be the average of the cost of x units.
AO3 – Draw diagrams illustrating the relationship between marginal costs and average costs, and explain
the connection with production in the short run.
The marginal and average costs relates to the production in the short turn because every small change in
price or quantity can lead to a whole new average cost and marginal cost.
AO3 – Explain the relationship between the product curves (average product and marginal product) and the
cost curves (average variable cost and marginal cost), with reference to the law of diminishing returns . The
marginal product curve is 'n' shaped because of the law of diminishing returns. As you add
more units of a variable factor, at first, the marginal product rises, (this is because the fixed
factor is under-utilised, so adding more units of the variable factor will increase the output
from each additional unit). But after a certain point, the marginal product begins to fall, as the
fixed factor input becomes diluted amongst workers and so you get less from each additional
unit of the variable factor.
Production in
the long run:
returns to
scale
Costs of
production in
*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.
AO2 – Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to
scale.
Increasing returns to scale: When our inputs are increased by m, our output increases by more
than m.
Decreasing returns to scale: When our inputs are increased by m, our output increases by less
than m.
Constant returns to scale: When our inputs are increased by m, our output increases by
exactly m.
AO1 – Outline the relationship between short-run average costs and long-run average costs.
The relationship between these two curves is that a long run average cost curve consists of
the long run
several short run average cost curves, each of which refers to a particular scale of operation.
AO3 – Explain, using a diagram, the reason for the shape of the long-run average total cost curve.
Both curves are u shaped the short run average cost curve rising because of labour
specialization and better spreading of fixed costs and it rises due to the law of diminishing
returns. The long run average cost curve falls because of economies of scale and rises because
of dis-economies. The long run average cost curve must comprise of all the lowest points of
each of the short run average cost curve because no firm will operate at a level of higher costs
in the long run than in the short run. The long run average cost curve must always be equal to
or lie below any short run average cost curve because in the long run all factors of production
can be variable.
AO2 – Describe factors giving rise to economies of scale.
In microeconomics, economies of scale are the cost advantages that an enterprise obtains due
to expansion. There are factors that cause a producer’s average cost per unit to fall as the
scale of output is increased. "Economies of scale" is a long run concept and refers to
reductions in unit cost as the size of a facility and the usage levels of other inputs increase.
More simply put, when more goods can be produced on a larger scale with lower costs,
economies of scale is said to be achieved.
AO2 – Describe factors giving rise to diseconomies of scale.
Diseconomies of scale occurs when Average Costs start to rise with increased output. Therefore there
will be decreasing returns to scale
· Diseconomies of scale can occur for the following reasons:
1. Poor communication in a large firm
2. Alienation: Working in a highly specialized assembly line can be very boring, if workers become de
motivated. In a large firm there is an increased gap between top and bottom e.g. call centers
3. Lack of control: when there is a large number of workers it is easier to escape with not working very
hard because it is more difficult for managers to notice shirking.
Firms may attempt to overcome diseconomies of scale by splitting up the firm into more manageable
sections.
Factors giving rise to diseconomies of scale include problems of coordination and communication.
Revenues
Total
revenue,
average
revenue
and
marginal
revenue
AO2 – Distinguish between total revenue, average revenue and marginal revenue.
Total Revenue-may be defined as the total receipts of (Hi firm from its sale. Total revenue is
equal to total number of commodities multiplied by price per unit of commodity. Total
revenue depends on the total sale. For example if a firm sells 60 of commodities at unit price
Rs.20, the total revenue of the will be equal to 60 X Rs.20 - Rs.1200.
Average Revenue is the revenue per unit of the commodity it is calculated by dividing total
Revenue by the number of old to the customers. For example if the total amount of 60 units of
shirts is Rs.3000, the average revenue per unit list.3000 -r 60 = Rs.50.
Marginal revenue at any level of firm's output is the net revenue added to the total revenue by
selling an additional unit of the product. In other words Marginal Revenue is the addition to
total revenue earned by selling n units of product instead of (n-1) units
AO4 – Illustrate, using diagrams, the relationship between total revenue, average revenue and
marginal revenue.
NOTE: You must be able to calculate total revenue, average revenue and marginal revenue
from a set of data and/or diagrams.
Profit
Economic
profit
(sometimes
Economic profit is the case where total revenue exceeds economic cost.
Normal profit is the amount of revenue needed to cover the costs of employing self-owned resources
(implicit costs, including entrepreneurship).
known as
supernormal
profit or
abnormal
profit) and
normal profit
(zero
economic
profit
occurring at
the breakeven point)
Economic profit is profit over and above normal profit, and that the firm earns normal profit when economic
profit is zero.
Loss is negative economic profit arising when total revenue is less than total cost.
AO3 – Explain why a firm will continue to operate even when it earns zero economic profit.
Firms in a competitive firm tend toward this outcome because this does not mean the firms are
receiving zero returns, rather an average return. The Zero-Profit Theorem states that entry into a
competitive industry will continue until all opportunity for positive economic profit is reduced to zero.
A competitive firm maximizes profits by producing at a price and output where marginal cost (MC) is
equal to marginal revenue (MR), or in other words, where MC is equal to price. When this price is
more than average costs (AC), the firm earns a positive economic profit.
NOTE: You must be able to calculate different profit levels from a set of data and/or diagrams.
Goals of the Firm
Profit
maximization
Alternative
goals of
firms
The goal of profit maximization is where the difference between total revenue and total cost is maximized or
where marginal revenue equals marginal cost.
AO2 – Describe alternative goals of firms, including revenue maximization, growth maximization,
satisficing, and corporate social responsibility.
In reality firms may not always have the main aim of maximizing profits. Not everyone has studied
economics! Other aims followed by entrepreneurs may be:
Revenue maximization: they often measure success by the amount of revenue they make.
Growth maximization: companies may set their target to achieve growth in the short run, rather than profits,
in order to gain a large market share and then dominate the market in the long run.
Satisficing: is when an economic agent aims to perform satisfactorily rather than to a maximum level, in
order to pursue other goals.
Corporate social responsibility: this is where a business includes the public interest in its decision-making.