Lecture VIII – Theory of the Firm
The Firm
Firm Organization
A firm – a firm is an institution that hires factors of production and organizes them to
produce and sell goods and services.
Primary goal of the firm
Maximize profit (  )
Profit = Total revenue – Total cost
Why firms are used instead of separate market activities:
1) Minimizes transactions costs:
Search cost of finding people to do business with
2) Economies of scale: cost of producing a unit falls as output rate rises.
Advantages of size
3) Team production: specialization within a firm, then combine output as a
team
Principal-Agent Relationships
There are several relationships in a firm in which one individual or groups’ behavior
influences outcomes for another group or individual.
Shirking – is when someone goofs off on their side of the relationship
1) not keeping costs as low as possible
2) lower than potential productivity
3) bad behavior
Ways to deal with shirking:
1) Payment schemes designed to minimize shirking
(in the form of incentives and disincentives)
2) Monitor Workers
Types of Firms
Proprietorships – firm with single owner
- Unlimited liability (legal responsibility for all debts of a firm up to an amount
equal to the entire wealth of the owner)
Profits taxed as personal income
Partnership - two or more owners with shared (joint) unlimited liability (8% of firms
are this type and account for 4% of total sales)
Profits taxed as personal income
Corporation – a firm owned by one or more limited liability stockholders only liable
up to the amount of their initial investment (19% and accounts for 90% of total sales)
Profits taxed twice – once as firm profit, once as stockholder income
II. Production Theory
Output
The production function is the technological relationship that exists between the quantity of
inputs employed and the quantity of output produced.
Output = f (inputs) or q = f (inputs)
Inputs (factors of production)
1)
2)
3)
4)
Land – natural resources
Labor – human resources
Capital – machines, building
Entrepreneurial skills
Fixed inputs – machinery, buildings, land (cannot be varied in the short run)
Capital is the input most commonly considered fixed.
Variable inputs – labor, materials (can be varied in the short run)
Labor is the input most commonly considered variable.
Time periods
Two time periods are used to describe the economic activity and decision making of firms:
1) Short-run – is a time period short enough that at least on of the inputs is fixed, firm
cannot choose from among all possible production techniques.
2) Long-run – is a time period sufficient for all inputs used in a productive process to
be variable, and we can choose from all possible production techniques.
(However, the basic technology of production cannot be changed).
(The firm’s planning decisions are long run decision because they are made from
given technological possibilities but with freedom to choose from a variety of
production processes that will use factor inputs in different proportions).
Example: If a building is leased for one year to use in production, in the short run
(one year) the input is fixed, however, after the one year lease has expired (the long
run) and the building input has become variable. You can quit renting the building or
you can renew the lease.
Making production choices in the short run
If we combine varying amounts of the variable input with the fixed input we can examine
the productive relationship.
Total Product
The maximum total output (measured in units of the product) that can be produced from a
given level of fixed and variable inputs. (TP) (see column 3 below)
Example:
Variable input = number of workers (labor L) (see column 1 below)
Fixed input = a machine (capital or K) (see column 2 below)
(1)
Number of
workers, L
(2)
Units of fixed
factor, K
(3)
Total Product ,
TP
0
1
2
3
4
5
6
7
1
1
1
1
1
1
1
1
0
2
5
9
12
14
15
13
(4)
Marginal
Product of
Labor, MPL
0
2 = (2-0)
3 = (5-2)
4 = (9-5)
3
2
1
-2
(5)
Average
Product of
Labor, APL
0
2 = 2/1
2.5 = 5/2
3.0 = 9/3
3.0
2.8
2.5
1.86
The Average Product, (AP), of a variable factor of production is the total product divided
by the amount of the variable input that is being employed. This measure tells us the average
amount of output that each unit of the input enables us to produce.
AP = TP/(amount of input)
The average product of the labor input would be denoted APL, (See column 5 above).
The level of output where the average product of labor reaches its peak, somewhere between 9
and 12 units of output, is called the point of diminishing average productivity. Up to that point,
average productivity is increasing, but beyond that point, average productivity is decreasing.
The Marginal Product of a variable factor of production is the change in total output that
occurs when an additional unit of that factor is employed. (MP) = TP/ input
We can calculate MP for each variable input if we have more than one input used in the
productive process. Fir this problem, the variable input is labor so we use MPL. (see column 4
above)
Note that as more and more units of labor are added, MPL first increases, 0 to 2 to 3 to 4 and then
decreases, 4 to 3 to 2 to 1 to –2. This is similar to the idea of diminishing marginal utility that we
discussed as part of consumer theory.
The level of output at which marginal product reaches as maximum is called the point of
diminishing marginal productivity. This level of output would be 9 units.
The fact that MPL increases, then decreases and even becomes negative, says that total product
increases, at first at an increasing rate then at a decreasing rate, and then at L =7 and MP L = -2,
total product actually starts to decrease.
In the range from 0 to 3 units of labor we say the increasing marginal returns exist. Within this
range, as labor increases by additional units, TP increases by larger and larger amounts.
In the range from 3 up to 6 units of labor, as each unit of labor is added, TP still increases, but
by smaller and smaller amounts. (i.e. MPL is getting smaller and smaller). This
phenomenon is referred to as diminishing marginal returns.
The law of diminishing returns (or marginal returns): The postulate that as more and more
units of a variable resource are combined with a fixed amount of other resources, employment of
additional units of the variable resource will eventually increase output only at a decreasing rate.
Once diminishing returns reached, it will take successively larger amount of the variable factor to
expand output by one unit.
As the 7th unit of labor is added, the marginal product of labor becomes negative causing TP to
fall from 15 to 13 units of output. Over this range we say we are experiencing absolute
diminishing returns.
Examples of why this occurs:
1) flower pot – farm
2) too many cooks in the kitchen
3) library
Region I exhibits increasing marginal returns
Region II exhibits decreasing marginal returns
The MP curve represents the slope of the TP curve. When MPL = 0, TP is flat at its peak. (see
point *)
III. Costs of Production (in the short run)
Total Fixed Costs – costs which do not depend on the level of output. They must be paid
whether you produce or not. (TFC) (Fixed costs are also called overhead costs). (Fixed costs are
usually considered to be sunk costs or unavoidable costs once they have been incurred). (see
column 2 below).
Examples: cost of machinery and rental cost of building
Total Variable Costs – costs which depend on the level of output. Examples: wages to labor,
costs of materials, energy costs of production. (These costs are considered opportunity costs or
avoidable costs). (These costs are zero if you don’t actually produce anything). (TVC) (see
column 3 below).
Total Costs = TFC + TVC, (see column 4 below)
Example:
Output
(1)
0
1
2
3
4
5
6
Total
Fixed
Costs
(2)
$100
100
100
100
100
100
100
Total
Variable
Costs
(3)
$0
40
70
90
120
160
220
Total
Costs
(4)
$100
140
170
190
220
260
320
Marginal
Costs
(5)
$40
30
20
30
40
60
Average
Variable
Costs
(6)
$40
35
30
30
32
36.7
Average
Fixed
Costs
(7)
$100
50
33.3
25
20
16.7
Average
Total
Costs
(8)
$140
85
63.3
55
52
53.4
Marginal Costs – of production are the costs of producing one more unit of a good or service,
which is equal to the change in total costs of production incurred by producing one more unit.
(MC)
(also called incremental costs)
Average total cost = TC / number of units produced = ATC
Average variable cost = TVC / number of units produced = AVC
Average fixed cost = TFC / number of units produced = AFC
ATC = AVC + AFC
Graphs of the TC (3), TVC (2), and TFC (1) curves and the MC, ATC, AFC, and AVC
curves
Things to notice on the graphs:
The distance between the TC and TVC curves is always the amount of TFC since TC = TVC +
TFC, TC – TVC = TFC
The marginal cost curve passes through the ATC and AVC curves at their low points.
The distance between the ATC and AVC curves at each level of output is equal to the AFC at that
point since ATC – AVC = AFC.
The output level associated with the low point of the ATC curve is called the capacity of the
firm. Any level of output past this point is considered past the firm capacity in terms of costs. If a
firm is producing less than this output level they are said to have excess capacity.
The relationship between costs and production: Up to point *, total cost increases at a
decreasing rate because total product is increasing at an increasing rate. At output levels greater
than *, total cost is increasing at an increasing rate because total product is increasing at a
decreasing rate.
Short run ATC curves mare U-shaped due to increasing and decreasing marginal returns.
The downward sloping part of the ATC curve reflects increasing marginal returns at the
upward sloping half of the ATC curve reflects diminishing marginal returns.
IV. Cost in the Long Run
A. Shape of the Long Run Average Total Cost Curve
All inputs are variable so TFC = 0 and TC = TVC, AFC = 0 and AVC = ATC
Now that Capital is also varying we are changing number of machines or buildings, but primarily
PLANT SIZE and Technology
Long Run Decisions are riskier
The short run decision might involve how many workers to use
The long run decision involves things like whether or not to expand a plant size
Take out loans, etc.
Stuck with your decision for along time
When making these decisions, we strive for economic efficiency:
Economic Efficiency: Using the method of production that produces a given level of
output at the lowest possible cost.
As opposed to technological efficiency
Technological Efficiency: A situation in which as few inputs as possible are used
to produce a given output.
EXAMPLE:
When you must pick things like plant size, each plant size has a related SRATC curve
If the firm wants to produce output q1 they will select firm size 1
If the firm wants to produce output q2 they will select firm size 1
If the firm wants to produce output q3 they will select firm size 2
If the firm wants to produce output q4 they will select firm size 2
The darkened portion of these curves make up the LRATC curve
The LRATC (long run average total cost curve) shows the minimum average costs
when the firm is free to choose from among all possible capital investments (plant
sizes)
The LRATC is also called the planning curve
It makes an envelope around the short-run average total cost curves
If the market demands 4 million units of a good and we have cost structures as follows:
Is it cheaper to have 4 firms each producing 1 million units or 1 firm producing 4 million units?
Again, the darkened area shows optimal firm size associated with each output level, so this is the
LRATC made from segments of the SRATC curves.
B. Why might bigger be better?
Why might it be cheaper for one large firm rather than 4 smaller firms?
(Why per unit costs are lower when you produce large levels of output)
1) high start up costs
indivisible set up costs – the cost of an indivisible input for which a certain minimum
amount of production must be undertaken before the input becomes economically feasible to
use. Minimum efficient scale of production.
2) Adopt mass production techniques
If someone wants to produce 10 sweaters, they will probably do it by hand. But if you want to
produce one million sweaters you will probably buy a knitting machine.
3) specialization and division of labor
If you only want to produce 10 sweaters, you may also do it alone. But if you are producing
millions, it will make sense to divide different tasks among different workers. One sort yarn.
One spool yarn. One feeds knitting machine. One pieces sweaters parts together. Someone
else folds and packages.
4) learning by doing
If you go into business making sweaters and he don’t know how to knit at first, the more
sweaters you produce, the better you will become at knitting. So with each additional sweater,
you can produce it in a shorter amount of time, so at lower cost.
5) Quantity discounts
Larger producers that buy inputs in greater bulk – get better prices on inputs.
6) Economies of Scope
The costs of producing products are interdependent so that producing one good lowers the
cost of producing another.
Colgate – Palmolive produces soaps, lotions, shampoos, tooth paste, etc. These products use
similar productive processes, and involve similar research and development. Time and effort put
into one of these products may also make them better at producing the others.
C. Returns to Scale
Economies of scale (Increasing returns to scale) when average costs falls as output (firm size)
rises
Explained by the things we just discussed about why bigger might be better.
Region I
Diseconomies of scale (Decreasing return to scale) when average costs increase as output (firm
size) rises
Region II
Why:
1) Organizational complexity – firms get too big
a) more opportunities for shirking
b) more costly to have additional monitoring
c) loss or team spirit or moral in the workplace
Constant return to scale
When per unit costs don’t change as output rises (region III)
Downsizing – a recent trend indicating that many firms have gotten too big and they are in the
diseconomies range. They downsize – or get smaller – to move back on the LRATC curve to
where they experience economies or constant returns to scale.
Also, there have been a lot of large conglomerate mergers lately.
Decreasing returns to scale and diminishing returns are two very different concepts.
Decreasing returns is a long run concept that looks at long run ATC curve. It tells us how average
costs change as firm size changes.
Diminishing marginal returns is a short run concept that tells us that in the short run as we add
more and more units of a variable input to a fixed input – additional output starts to decline. (Too
many cooks spoil the soup!)
V. The motivation of the firm – Profit maximization
Profit = total revenue – total cost
Ways of Measuring Cost of Production
1) Accounting Costs (also called explicit costs)
Direct measures such as
- costs of inputs
- interest payments on loans
- depreciation
2) Economic Costs (also called opportunity costs, avoidable costs, implicit costs and imputed
costs)
Economic costs include opportunity costs such as:
- forgone interest of funds used for business rather than in financial markets
- implicit rental rate, value of your property and capital equipment if you used it elsewhere
and were paid for it
- value of a manager’s or owner’s time if they work in their business but do not directly pay
themselves a wage
Opportunity cost of capital – is the implicit rate of return that must be paid to investors to
induce them continuously supply the funds necessary to maintain a firm’s capital assets.
Profit
1) Accounting Profit = Total revenue – explicit costs
does not include opportunity costs
2) Economic Profit = total revenue – (explicit and implicit costs)
Treats expenses as opportunity costs of production
If economic profits are zero, we say that we are earning a normal profit or normal rate of
return
VI. Sunk Costs or historical Costs
Costs that have already occurred. If they cannot be recovered, they should not effect our current
decisions. Current choice and things to do now or in the future should only be affected by current
costs and benefits or future costs and benefits that have not yet been occurred.
Suppose you go out to a fast food restaurant, go through the drive in window, and get a meal to
take home. If you get home and start to eat the food and it the worst tasting stuff you had ever had
in your life, do you eat it?
No. And economic theory says that they won’t. Some people feel that they have to do something
or use something because they already paid for it. But if you can’t get the money back, the money
is a sunk cost and should not effect your current decision.