THE THEORY
OF THE FIRM
DANIEL CHEN
WITH SOME MINOR HELP FROM HIS
MICROECONOMICS
• is a branch of economics that studies the
behavior of how the individual modern
household and firms make decisions to allocate
limited resources(WIKIPEDIA.ORG)
• This unit examines the behavior of the individual
firm and household in detail. You will learn the
reasoning and incentives behind firms and their
decisions. Ultimately, I am giving you the key, the
key to understanding how the world responds to
different situations. So, love it, learn it, memorize
it. Twenty years from now, you will live it.
The Costs of Production
• So what is the main goal behind a firm’s decision:
to reduce its costs and thereby increase its profit.
• Therefore, to best understand microeconomics
we must consider the costs and revenues each
firm faces:
• Total Cost– the market value of the inputs a firm
uses in production
• Explicit Costs: input costs that require an outlay
of money by the firm
• Implicit Costs: input costs that do not require an
outlay of money by the firm
COSTS OF PRODUCTION
• Accounting profit: total revenue minus total cost, including both explicit
costs
• Economic profit: total revenue minus total cost, including both explicit and
implicit costs
• Marginal Product: The increase in output that arises from an additional
unit of output
• Diminishing Marginal Product: The property whereby the marginal
product of an input declines as the quantity of the input increases
• Fixed Costs: costs that do not vary with the quantity of output produced
• Variable Costs: costs that vary with the quantity of output produced
• Average Total Cost: total cost divided by the quantity of output
• Average fixed cost: fixed cost divided by quantity of output
• Marginal Cost: the increase in total cost hat arises from an extra of
production
Cost Curves and Their Shapes
• ATC is U- shaped (This is because ATC = FC +
VC and FC declines as output increases and
VC increases as output increases)
• Rising MC (diminishing marginal product)
The Relationship Between MC and ATC
• Whenever marginal cost is less than average
total cost, average total cost is falling. When
marginal cost is greater than average total
cost, average total cost is rising.
• Marginal Cost crosses Average Total Cost at it’s
minimum point.
PERFECTLY COMPETITIVE MARKET
• So what makes a market perfectly
competitive?
• Consider the following:
1. Low entry and exit barriers
2. Identical products
3. No single buyer or seller has a large impact
upon the market price: EVERYBODY IS A
PRICE TAKER
A PERFECTLY COMPETITIVE FIRM
• So, now that we understand the basics and
conditions behind a perfectly competitive
market, we should be able to analyze the
decisions and reasoning behind the individual
firm:
Profit Maximization
• Firms produce at the output where the MC
and MR curves cross.
• This is because…
• If MR is greater than MC, the firm will earn a
profit by increasing output
• If MC is greater than MR, the firm will earn a
profit by decreasing output
I’m Shutting YOU DOWN
• So what influences a firm’s short run decision to shut
down?
• A firm shuts down if the revenue that it would get from
producing is less than its variable costs of production
• In other words, when TR<VC
• Or by dividing both sides by Q when
• P<AVC
• In the short run fixed costs are a sunk cost: a cost that
has already been committed and cannot be recovered.
When does a firm EXIT?
• So when does a firm make the long run decision
to exit the market?
• A firm exits the market if the revenue it would get
from producing is less than its total costs.
• This can be expressed as…
• TR< TC or when dividing both sides by Q
• As P<ATC
• In the long run decision to exit the market, FC is
no longer viewed as a sunk cost
Measuring Profit
•
•
•
•
•
Profit= TR-TC
We can rewrite this definition as..
(TR/Q-TC/Q) X Q
All I did was factor Q out
Therefore Profit= (P-ATC) Q
So in a graph, to determine the profit a firm is
making, simply go down from Price to the ATC
and multiply this value by the Profit
maximizing Q of output
MONOPOLIES
• monopoly :Market in which there is a sole supplier
of a product with no close substitutes
• An important characteristic of a monopolized
market is barriers to entry  new firms cannot
profitably enter the market
• Some things that can cause Barriers to entry are
– Legal restrictions
– Economies of scale
– Control of an essential resource
Revenue for the Monopolist
• Because a monopoly is the single firm in the market, the demand
curve for a monopolist is also the market demand
• The demand curve for the monopolist’s output therefore slopes
downward
• MR is below demand in a Monopoly due to the output and price
0
effects.
• After MR crosses the x axis, Demand becomes inelastic
Elastic
Unit elastic
Inelastic
D = Average revenue
Marginal revenue
Firm’s Costs and Profit Maximization
• Because the monopolist controls the market price, we can
say that the monopolist is a price maker
• For the same reasons as that of a competitive firm,
monopolies produce where MR=MC. They then move up to
the demand curve to find the corresponding price to charge.
Marginal cost
The profit for a
monopolistic firm is
also found in the
same manner as
that of a perfectly
competitive firm
Average total cost
a
Profit
b
e
MR
0
10
16
D = Average revenue
32
DEADWEIGHT LOSS YO!
• A monopolist produces less than the socially
efficient level of output because, not
everybody that values the good at its marginal
cost is able to purchase the good.
Perfect Price Discrimination
• If a monopolist could charge a different price
for each unit sold, the firm’s marginal
revenue curve from selling one more unit
would equal the price of that unit and the
demand curve would become the marginal
revenue curve
• A perfectly discriminating monopolist charges
a different price for each unit of the good
Perfect Price Discrimination
A perfectly discriminating
monopolist would maximize
profits at point e where marginal
revenue equals marginal cost 
price set at point e
a
Profit
e
c
Long-run
average cost
= marginal cost
D = Marginal
revenue
0
Q
18
Quantity per period
Increasing Competition
• Governments institute antitrust laws when a
monopoly grows to powerful, to encourage
competition in the market
Monopolistic Competition
• Power to set prices somewhat like a monopoly
• Face competition like that of a perfectly
competitive firm
 Large number of firms
-- Each firm has relatively small market share
 No barriers to entry or exit
Characteristics of Monopolistic
Competition
• Product Differentiation – Each firm makes a
product that is slightly different from the
products of competing firms.
 Firms compete in Quality, Price, and Marketing
-- Quality: design, reliability, service provided to
buyer and ease of access to product
-- Price: determined by the downward sloping
demand curve
-- Marketing: firm must market and advertise to
attract customers
Profit Maximization
• Due to the product differentiation within a
monopolistically competitive firm, this type of firm
operates very similarly to a monopoly in the short run.
• To maximize profit, a monopolistically competitive firm
produces at the output where MC equals MR and goes
up to the demand curve to determine Price.
• In the long run, due to no barriers to entry or exit, the
firm earns zero economic profit.
• A monopolistically competitive firm produces an excess
capacity ( doesn’t produce at min. ATC)
• A monopolistically competitive firm marks up its price
over MC
COST TO WELFARE
• Because of the mark up in price over Marginal
Cost in a monopolistically competitive firm,
dead weight loss occurs.
• However, reducing this deadweight loss is
difficult since the firm already produces a zero
profit.
Advertising
• To encourage consumers to purchase their
products, Monopolistic firms use
advertisement.
• Firms that advertise tend to have higher
quality goods and more loyal customers, than
firms that don’t advertise.
• Some may argue that advertising manipulates
people’s tastes.
Oligopoly
– An Oligopoly is a market type in which:
• A small number of firms compete.
• Natural or legal barriers prevent the entry of new firms.
• Small Number of Firms
– In contrast to monopolistic competition and perfect
competition, an oligopoly consists of a small number
of firms.
• Each firm has a large market share
• The firms are interdependent
• The firms have an incentive to collude
Collusions and Cartels
When a small number of firms share a market, they
can increase their profit by forming a cartel and
acting like a monopoly.
– Cartel: a group of firms acting together to limit
output, raise price, and increase economic profit.
– Cartels are illegal but still do operate in some
markets.
– Despite the temptation to collude, cartels tend to
collapse.
Game Theory
– Game theory examines the interdependence of
firms in an oligopoly:
– When a small number of firms compete in a
market, they are interdependent in the sense that
the profit earned by each firm depends on the
firms own actions and on the actions of the other
firms.
– Before making a decision, each firm must consider
how the other firms will react to its decision and
influence its profit.
Game Theory
• To better depict Game Theory I will use an example: The
Prisoner’s dilemma--A game between two prisoners that
shows why it is hard to cooperate, even when it would be
beneficial to both players to do so.
– Art and Bob been caught stealing a car: sentence is 2
years in jail.
– DA wants to convict them of a big bank robbery:
sentence is 10 years in jail.
– DA has no evidence and to get the conviction, he
makes the prisoners play a game.
•
PRISONERS DILEMMA
– Rules
– Players cannot communicate with one another.
• If both confess to the larger crime, each will receive a sentence of 3 years for
both crimes.
• If one confesses and the accomplice does not, the one who confesses will
receive a sentence of 1 year, while the accomplice receives a 10-year
sentence.
• If neither confesses, both receive a 2-year sentence.
– Strategies
– The strategies of a game are all the possible outcomes of each player.
– The strategies in the prisoners’ dilemma are:
• Confess to the bank robbery
• Deny the bank robbery
Dominant Strategies and Nash EQ
Both Bob and Art reason that
no matter the decision of the
other, he or she will be better
of confessing. Therefore both
pursue their dominant
strategies: a strategy that is
best for a player in a game
regardless of the strategies
chosen by other players. As a
result, both Bob and Art
confess. This outcome, where
dominant strategies are
pursued is Nash Equilibrium.
“DANIEL CHEN HAS DONE A PHENOMENAL JOB
WITH HIS REPRESENTATION OF THE THEORY OF
THE FIRM. HE DESERVES A NOBEL PRIZE FOR HIS
ACCOMPLISHMENTS”-RUSS B.