Theory of the Firm:
Basic Concepts
Product, Costs and Profits
Direction and Motivation
• Opening the “blackbox “ of Firms (Producers)
to understand the supply curve more
• The types of industries (market structure)
they operate under
• Analytical Method
– Introduce the fundamental concepts of firms -performance and behavior
– Conduct efficiency analysis and justify the
possible reasons for government interventions
Fundamental Concepts:
• Fundamental concepts necessary to analyze the behavior
and performance of a firm
– Production/Output = Q or P (NOT price)
– Costs= C
– Revenue = R
– Profit = π
• What kind of indicators pertaining to these variables can
we think of to effectively analyze the firm? Imagine you
will be given massive amount of data of the above
variables e.g. each week, each month, for many years.
How would you make sense of this massive data?
– Our focus: Total, Marginal, and Average Values
• And what can you with these indicators in order to help
us make quick and good decisions?
Operation of a firm
• A firm purchases inputs and uses them to
produce output for sale.
• It is ASSUMED that the aim is to make profits.
• The Input-Output Process is the technical
relationship between Input and Output. It can
also be envisioned as the technology of
PRODUCTION
The “process” depends on…
• The technical relationship between the inputs
and output and thereby how firms behave,
dependentson the time dimension the firm is
operating under
• i.e. the short run vs. the long run
• To effectively analyze the behavior and
performance of the firm, it is essential to use this
classification between the short run vs. long run
Short Run
• The short run is a time period during which at
least one input is fixed and cannot be changed
by the firm
• e.g. if the firm wants to increase output, it can
hire more labor, buy more tools and raw
materials (variable inputs)
• but it cannot quickly change the size of its
buildings, factories, and heavy machinery
(fixed inputs)
Long Run
• The long run is a time period during which all
inputs can be changed.
• e.g. in the long run, the firm can build new
buildings, factories, and buy more heavy
machinery
• The firm can change all its inputs. The firm has
no fixed inputs and all inputs are variable
•  NOTE: the short run vs. the long run do NOT
correspond to any particular length of time.
Some industries may require months to change
their fixed inputs while other may require years
Describing the Production/Output in
the Short Run
• We start with the analysis of the production (level of
output) of the firm in the short run
• e.g. envision a simple farm as the firm. It has only
two inputs, land or capital (which is the fixed input)
and labor (which is the variable input). The only way
the farm can increase the quantity of its output in
the short run is by increasing the quantity of the
varible input, labor it uses
Introducing the Total Product, Marginal
Product, and Average Product Group VI
• Product = Output = Production
• Total Product (TP) is the total quantity of output
produced by a firm
• Marginal Product (MP) is the extra or additional output
resulting from one additional unit of the variable input
(i.e. labor). It tells us how much output increases as
labor increases by one unit (eg one worker or one hour)
• Average Product (AP) is the total quantity of output per
unit of variable input. It tells us how much output each
unit of labor produces on average
Example (also Widgets)
• To find the MP, we take the change in TP and divide
by one unit increase in labor e.g. the MP of the third
worker is (9 – 5)/(3 – 2) = 4
•
 Pages 3 and 4 of H/O
TP, MP, and AP Curves
• What trends do you see? What relationships do
you see? What kind of mathematics are we
using? And WHY are they patterned this way?
•
 graphs of continuous functions
The relationship between the Average and
Marginal curves
• Note the relationship between AP and MP curves: when the
MP lies above the AP curve (MP > AP), AP is increasing; and
when the MP curve lies below the AP curve (MP < AP), AP is
decreasing … Why is this so?
(continued)
• Consider a simple example using your average
test scores or your GPA. Say you have an average
of 80 in your tests so far and you would like to
increase your average
• Now, if your next test score (the marginal score)
is greater than your average of 80, your average
will………….. But if your next test score is lower
than your average of 80, your average will………….
•  This is why the AP and MP is patterned the
way described above. Moreover, this pattern
implies that the MP curve always intersects the
AP curve at its maximum point
Now, why (conceptually) are the TP, MP,
and AP curves shaped the way they are?
• The data used is not a random set of data. In
fact, it characterizes the majority of the firms
behavior in the short run of real life setting. That
is, the pattern characterizes the technical
relationship between inputs and outputs in the
short run
• Why is then the TP, MP and AP patterned this
way? What economic concept explains this
phenomena?
Marginal Returns in the SR
• Returns = extra output
• As more and more units of a variable input (eg labor)
are added to one or more fixed inputs (eg capital),
the marginal product of the variable input at first
USUALLY increases (due to division of labor or
specialisation) but it will eventually begin to decrease
• 
• Law of Diminishing Returns If one input
is fixed, then employment of additional
units of the variable factor will
eventually result in a diminishing
marginal product.
(continued)
• The Law of Diminishing Returns happens because
each additional workers has less and less capital (fixed
input) to work with, and so produces less and less
• ---no longer the OPTIMUM RATIO OF LABOR TO
CAPITAL
• “Too many cooks spoil the broth”
• Also a realistic portrayal of firm’s operation. There
cannot be unlimited returns given at least some fixed
inputs
• For this reason, in real life, for companies to be
successful, they must keep forecasting the future
business opportunities and investing in new
machines, factories, etc. (the fixed inputs) in order to
avoid the diminishing returns! but then we are in
the long run
Costs of Production
• Costs of production (costs of inputs) include
money payments to buy resources plus
anything else give up by a firm for the use of
resources
• Resources (factors of production and inputs)
and its cost include:
– Land  Rent
– Labor  Wage
– Capital  Interest
– Entrepreneurship  Profits
Costs as Opportunity Costs
• Because of scarcity, the use of any resource by a
firm involves a sacrifice of the next best
alternative use of that resource, which is an
opportunity cost
• All production costs are opportunity costs and are
also referred to as economic costs
• This understanding helps us clarify/classify two
types of costs underlying production or economic
costs:
–
–
–
–
Explicit Costs
Implicit Costs
Explicit Costs + Implicit Costs = Economic Costs
 window cleaner example
Explicit vs. Implicit Costs
• Economic costs comprises of two kinds
depending on who owns the resources used
by the firm: either owned by the firm itself or
by householders from whom the firm buys
resources
• When the firm uses resources it does not
own, it buys them from households .These
payments made by a firm to acquire resources
of production are called the Explicit Costs
– e.g. firm hires labor and pays wages (including to
the CEO); purchases materials and tools from a
seller; uses electricity and pays its bills; pays
interest on loans
Explicit vs. Implicit Costs (continued)
• The firm may own some of the resources that it uses
e.g. office building. In this case, the firm does not
make a money payment to acquire the resource. But
cost is the sacrifice of income that would have been
earned if the resource had been employed in its next
best alternative use. This sacrificed income arising
from the use of self-owned resources by a firm is called
Implicit Costs
– e.g. for land, the rental income from the building you
owned; for the entrepreneur= the extra
risk and uncertainty in running the
company . He needs to be paid for his
entrepreneurial skill (= “normal
profit”)
Economic Costs (Explicit + Implicit
Costs)
• Economic costs are the sum of explicit and
implicit costs, or total opportunity costs
incurred by a firm for its use of resources,
whether purchased or self-owned. When
economists refer to “costs” they mean
“economic costs”.
• Therefore “normal profit” is part of economic
costs
Economic Costs and PROFIT
REVENUES
COSTS and Economic Profit
Accounting costs and
profit
800,000
yen
PROFIT=
Accounting
Profit=
Implicit costs:
100 000 (or “normal
profit)
Explicit costs:
Wage = 600,000
Materials= 50,000
Interest on loan= 5000
Total = 655,000
Explicit costs:
Wage = 600,000
Materials=
50,000
Interest on
loan= 5000
Total = 655,000
In the Real World…
• In the real world or business world, we only see and
record the explicit costs and calculate profits accordingly
(aka accounting profits)
– The job of Financial Accountants, certificate in Certified Public
Accountant
• Implicit costs are really an imaginary concept. There is no
one method of defining them It can get quite
psychological and they usually are impossible to measure .
Yet, it is again important as we make decisions
– E.g. the decision to become a teacher vs. a government official –
different pros and cons; different benefits and costs for which I
cannot really add a monetary value
– Decision to start a business, decision to change your major and
degree… there are some sort of implicit cost
– When we take into account of implicit cost we define Economic
Profit
PROFIT
π
• ECONOMIC PROFIT (or POSITIVE or ABNORMAL)=
• REVENUE − COSTS
• Where costs include IMPLICIT costs (or normal
profit) as well as EXPLICIT costs
• ________________________________________
• ACCOUNTING PROFIT
•
= Implicit costs+ economic profit
• OR
• ACCOUNTING PROFIT
•
= normal + abnormal (economic) profits.
More on Profit
• If TR = TC  firm is making……………………
• It is BREAKING EVEN
• However, it is making ……………….accounting
profit
• If TR>TC firm is making……………………
We can illustrate the three cases as follow…
The Cost of Production in the Short Run
• Costs = f (Output)
• The short run has at least one input which is fixed
 fixed cost, variable cost, and total costs
• Fixed costs (FC) do not change as output changes
e.g. rental payments, property taxes, insurance
premiums, interest on loans, etc.
(Group VI)
– Do not increase or decrease with output, even if there
is zero output, these payments have to be made in the
short run… but in the LR, if there is zero output, if you
were a CEO, then might want to consider descaling
your business or close it down
(continued)
• Variable costs (VC) arise from the use of
variable inputs. There are costs that vary
(change) as output increases or decreases e.g.
wages of labor, electricity bill, gas and oil cost,
etc.
– To produce more, the firm needs to use more
variable inputs which increases the variable costs
• Total costs (TC) are sum of (total) fixed and
(total) variable costs
TC = TFC + TVC
Average and Marginal Costs
• Average costs (AC) =
• cost per unit of output or total cost divided by
the number of units produced
– They tell us how much each unit of output produced
costs on average
• From the definitions above, we have three types
of average costs (AC)
AFC = TFC/Q
AVC = TVC/Q
ATC = TC/Q or AFC + AVC
• Given the definitions of TC, FC, and VC what kind of
values and pattern do you think you will see in the
AC values?
Marginal Cost
• Marginal cost (MC) is the extra or additional cost
of producing one more unit of output. It tells us
by how much total costs (TC) increase if there is
an increase in output by one unit
• Mathematically, it is calculated by considering the
change in TC resulting from a change in one more
unit of output or RATE of CHANGE of costs
• It can also be calculated by considering the
change in TVC that results from a change in one
unit of output (because fixed costs do not change
with output)  New H/O and Pages5/ 6/7
Group VI
• REVIEW
1) Explain the shapes of the graphs above
• 2) how would you calculate the ACs and MC?
(iGroup III:
Review: the SR AC and MC Curves
• What pattern do you see?
–
–
–
–
AFC? AVC, ATC and MC?
What is vertical distance between ATC and AVC?
MC in relation to AVC and ATC?
Mathematically, MC is the slope of the TC curve.. TC curve has a
changing slope with Q (calculus and derivatives)
Review: Relating the cost and product curves:
the law of diminishing returns
• The MP and AP curves are mirror opposites (inverted shapes)
of MC and AVC curves
– MP and AP Curves: ∩ Shaped
– MC and ATC and AVC Curves: U Shaped
– Both are explained by the Law of Diminishing Marginal Returns
– When average product/output is increasing, this means that
each additional unit of output can be produced with fewer and
fewer units of labor. Therefore, the labor cost per unit of output
(AVC) falls (and vice versa)
– What are some reasons for this?
• Falling MC and AC: Specialization of labor; specialization of
management; efficiency of capital equipment for large scale
production
• Rising MC and AC: coordination and monitoring problems;
communication and people problems with more labor; Labor to
Capital ratio is larger than the optimum
More on Profit Break-Even
and Shut-Down Points
Group III and Vi
• Profits: TR – TC
• If TR>TC………………………………..
• If TR= TC………………………………..
• But if If TR<TC………………………………..
• Will it shut down? (ie EXIT or QUIT the market)
Calculate TOTAL Costs&Revenues
P 1Q1 results in……………
P 2Q2 results in………………..……………
Calculate TOTAL Costs&Revenues
P 1Q2 results in…………… P 1Q1 results in……………
P 2Q1 results in………………..……………
Break-Even and Shut-Down
Prices/Points
• Use Pages 8 and 9 of Hand-out.
• the short run shut-down price is when
P=AVC.
• the break-even price is when P=ATC.
• a loss-making firm would shut down in the
short run when P<AVC
• a loss-making firm would shut down and exit
(quit) the market in the long run when P<ATC.
Production and Costs
in the Long Run
The Long Run
• Let’s now examine the long run relationship
between inputs and outputs. In doing so, it is
important to bear in mind that all inputs are
variable
• We are interested to see what happens to
output and production when the firm changes
all of its inputs
Recap: Short Run vs. Long Run
• The short run is a time period during which at
least one input is fixed and cannot be
changed by the firm
• The long run is a time period during which the
firm can change all its inputs. The firm has no
fixed inputs (and thus no fixed costs) and all
inputs are variable
Production and Costs in the Long Run
• We are interested in seeing what happens to
output when the firm changes all of its inputs
• There are three main patterns of production
(in relationship to inputs):
– Constant returns to scale
– Increasing returns to scale
– Decreasing returns to scale
 H/O page 10
(continued)
• Constant returns to scale means that output
increases in the same proportion as all inputs:
given a percentage change in all inputs, output
increases by the same percentage
• Increasing returns to scale means that output
increases more than in proportion to the
increase in all inputs: given a percentage change
in all inputs, output increases by a larger
percentage
• Decreasing returns to scale means that output
increases less than in proportion to the increase
in all inputs: given a percentage change in all
inputs, output increases by a smaller percentage
Note!
• Note the diminishing returns occur only in
the short run, because they show what
happens to output as variable inputs is added
to a fixed input
• It is not to be confused with decreasing
returns to scale which occurs in the long run
when all inputs are variable
Costs of Production in the Long Run
• Think of the long run as the firm’s planning
horizon. If the firm wants to expand production
and keep being competitive, it must think in
terms of increasing its fixed inputs, otherwise its
production will run into diminishing returns and
the market is competitive!
• They must simulate the various possible output
levels and the respective costs
• For example, consider the farmer who produces
with two inputs: land and labor. They are
planning the long run options which has 4
possible land sizes...
Characteristics/Features of the LRATC
• Shape of the LRATC curve. Three features:
– Economies of Scale
– Diseconomies of Scale
– Constant Returns to Scale
The U-Shape of the LRATC
• As you can see, the LRATC is U-Shaped just like
the SRATCs. But the reason for this is not to be
confused with the Law of Diminishing Marginal
Returns. It can be found in economies and
diseconomies of scale…
• Economies of Scale are decreases in the average
costs of production over the long run as a firm
increases all its inputs. It explains the
downward-sloping portion of the curve: as
output increases, and a firm increases all inputs,
average cost, or cost per unit of output falls
Reasons as to why Economies of Scale Occur
• There are several reasons why economies of scale
occur: (can also be categorised as
• technical; commercial; financial, managerial, and
risk-bearing)
– Specialization of labor (technical); – as production
increases (particularly at the lower level), more
workers are employed, allowing for greater labor
specialization. This increases efficiency and allows
output to be produced at a lower average cost
– Specialization of management (managerial) – more
production allow for more managers to be employed,
each of whom can be specialized in a particular area
(e.g. production, sales, finance
(continued)
– Efficiency of capital equipment (technical) – large machines
(e.g. power generator) used to produce large quantities of
output are more efficient than smaller ones, allowing
average cost to fall. But firms with small volume of output
(small amount of inputs) cannot utilize these and thus
operate with less efficient machines i.e. Indivisibilities of
capital and/or principle of increased dimensions
– Indivisibilities of efficient processes (technical) – some
production processes such as mass production, assembly
lines require large amount of production to be efficient and
ATC to fall i.e principle of multiples
– Spreading of certain costs such as marketing over large
volumes of output (commercial). Costs such as ads, R&D
result in lower average cost if they can be spread over large
volume of output
Diseconomies of Scale
• Diseconomies of Scale are increases in the
average costs of production over the long run
as a firm increases all its inputs. It explains
the upward-sloping portion of the curve: as
output increases, and a firm increases all
inputs, average cost, or cost per unit of output
increases
• Some of the reasons for diseconomies of scale
are as follow…
Reasons for Diseconomies of Scale
• Coordination and monitoring difficulties
– As firm grows larger and larger, there may come a point
where its management runs into difficulties coordinating,
organizing and cooperating within the firm. This results in
inefficiency and causes average costs to increase as output
increases
• Communication difficulties
– A large firm size may have difficulties in communication
between various components of the firm, again leading to
increase in inefficiency and average cost
• Poor worker motivation
– As output increases and amount of work increases,
workers could start to feel less motivated and less efficient,
leading to the average cost rising
• …
Constant Returns to Scale
• Constant returns to scale is the horizontal
segment of the LRATC where as output
increases (with all inputs increasing), average
costs do not change
• Now in the real world, firms are eager to take
advantage of economies of scale and try to avoid
diseconomies of scale. Therefore, they constantly
invest in their capital to upgrade their system and to
keep the efficiency high … this introduces the
concept of Technical or Productive Efficiency
• Qmes is where minumum AC starts. If it is quite low, there can be
many firms operating efficiently in that market or industry.
• But if it is at a high quantity, there are likely to be a small number of
firms such as heavy industries like steel, aluminum, etc. and
• In the extreme case, there may be only one firm that can operate
efficiently, called a natural monopoly