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 Ushaped, 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. Skilled labour becomes more readily available as it is concentrated in a
location
2. Shared facilities for R and D, sharing costs and logistics
3. Ancillary trades spring up: delivery, advertisements and upkeep, lower
delivery costs
4. Trade Associations may be set up, running training courses, etc
5. 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,
always occurs where MR = MC with MC rising,
applies to both price takers and price makers.

this
and

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?