Theory of the Firm

Theory of the firm attempts to explain how firms react to

levels of prices and changes to prices
This is eventually used to explain why supply curves look
like they do
Used to develop our understanding of economic theory
further

Theory of the Firm
Firms
Think of as legal entities
Types
1) Proprietorships
2) Partnerships
3) Corporations
Proprietorships & partnerships are easy to set up, but do not have
unlimited liability
Corporations have unlimited liability
For this course, assume all firms are Corporations
What do firms Do?
Maximize Profits
Theory of the Firm
Profit Function:
Max (Revenues Costs)
Production Function
Q = F(L, K)
Output (Q) is a function of Labour (L) and Capital (K)
Recall that in the short-run, capital is fixed but labour is
variable
Q = F(L, K)
Means fixed
Breaking Down the Profit Function
Profit Function:
Max (Revenues Costs)
Revenues:
Revenue = P x Q
Higher prices and higher sales lead to bigger Revenues
Costs:
Costs are related to output (Q)
The more output the more labour (L) & capital (K) (Costs) incurred
Short-run Analysis of Production Function
0
Capital is fixed in the short-run
To increase output, need to
increase labour
Overtime, hire short term
workers, etc.
Increases output of factories,
etc. (Capital)
Note that there are decreasing
returns as you add more labour
(i.e., machines maxed out,
people running into each other,
etc.)
L
Q
Q = F(L,K)
Decreasing
additional
output from
more labour
Resulting Cost Function
0
With capital fixed in
short-run, diminishing
returns to added
labour
Increased labour
means increased
costs
Hence, quadratic like
function
Q
Cost
C = ~F(L)
Increasing
cost with
increasing
labour
Average Product of Labour
0
To find average
product of labour APL,
draw a ray from the
origin to where the
company is operating
at
TP = Total Production
L
Q
TP
Q/L = APL
Decreasing
ATC
Q2
Q1
Q3
L1 L2 L3
Average Product of Labour
0
Where the ray from
the origin measures
the APL, the
marginal product of
labour (MPL) is
measured by the
slope of the tangent
to the curve at that
point
L
Q
TP
MPL = Q/ L
Q2
Q1
Q3
L1 L2 L3
Maximum Average Product of Labour
0
The maximum APL
occurs where the ray
is tangent to the curve
(short run)
This is the point where
the output per person
for that amount of
labour is max
(i.e., best average
output without running
into each other, etc.)
L
Q
Q = F(L,K)
Max APL
Q2
Q1
Q3
L1 L2 L3
Maximum Marginal Product of Labour
0
The maximum MPL
occurs where the
slope of the curve is
greatest (i.e, at the
inflection point)
This is the point where
the amount of output
from the next
additional unit of
labour, is the greatest

L
Q
TP
Q2
Q1
Q3
L1 L2 L3
Max MPL
MPL and APL
0
The APL and MPL curve appear
as such
The maximum MPL occurs at L*,
whereas the max APL occurs at
Lo
Relationship (for increasing L):
When marginal value > ave value,
then average is increasing
When marginal value < ave value,
then average is decreasing
When marginal value = ave value,
then the APL is at its maximum


L
Q
TP
L
0
PL
MPL Curve
APL Curve
L* Lo
Q/ L (Max)
Q/L (Max)
Short-run Analysis of Production Function
0
ATC function
corresponds to
production function with
increasing labour
(i.e., raising output in
the short-run by adding
additional labour)
TP = Total Production
L
Q
TP
Increasing
ATC
Decreasing
ATC
Average Cost Function
0
The relationship between
MPL and APL have the
following implications for
cost
Average Cost (AC)
At A, output (Q) rising
faster, relatively to the
rise in total cost TC
At B, output (Q) rising
slower relative to rise in
TC
Corresponds to
production function (see
next slide)
Q
Average
Cost
AC
Increasing cost with
increasing output
(by increasing
labour)
A B
Average Fixed Costs
0
Up until now we have
assumed labour has been the
only cost but in reality most
production processes have
fixed costs
Fixed costs are incurred even
if no production (e.g., building
rent, utilities)
the average fixed cost
declines as production
quantities increase (spread
over more units)
Analysis of fixed costs is often
important in answering the
question of what scale should
we be operating in?
Q
Average
Fixed
Cost
AFC = FC/Q
Average Total Cost
Q
Q
Q
AFC AVC
ATC
+
=
ATC = AVC + AFC
AFC = FC/Q
AVC = VC/Q
Cost analysis is a
big focal point of
microeconomics
and management
The reason being
is that cost data
is readily
available to
operating
businesses

Average Variable Cost
0
Q
Average
Cost So, AVC = TVC/Q ~
$ x L/Q
Where $ is wage
APL
Also APL = Q/L

Hence, AVC is about
equal to ~
$ x 1/APL

Called scaled
inverse function
Q
APL
AVC
Marginal Cost Curve
0
Marginal Cost = Additional
Cost of producing one
more unit
Similar to MPL & APL, (for
increasing Q) when MC <
ATC, then ATC is falling,
and when MC is greater
than ATC, ATC is rising.
Q
$
MC
0 Q
$
MC
ATC
Production Cost Analysis
0
Q
$
MC
AVC
ATC
FC
Marginal Cost Curve
For price taking firms (get $P1
for any unit sold), an analysis of
production capacity at the
margin can indicate what level
to produce at
Say production initially at Q1,
and raise to Q2
Extra revenue = (Q2-Q1)*P1
Additional profit (see graph)
Additional cost (see graph)
So additional revenue is > than
additional cost, therefore raise
production to Q2

0
Q
$
MC
P1
Q1 Q3 Q2
Additional
Profit
Additional
Cost
Marginal Cost Curve
Say production now at Q2 and
decide to raise to Q3
Extra revenue = (Q3-Q2)*P1
Additional cost (see graph)
So additional revenue is < than
additional cost, therefore dont
raise production to Q3
So given a price P1, should
produce Q2
0
Q
$
MC
P1
Q1 Q3 Q2
Additional
Cost
Marginal Cost Curve
If price were to rise to P3,
then optimal to produce at Q3
If price were to fall to P2, then
optimal to lower production to
Q1
MC curve provides a
relationship between P&Q
To maximize profit, a price
taking firm should set
production to the quantity
where MC=P
What kinds of firms are price
takers? E.g. agriculture,
commodities Perfect
Competition


0
Q
$
MC
P1
Q1 Q3 Q2
P2
P3
Marginal Cost Curve
For a price P1 with
production at Q1, the
revenue to the firm will
be Q1xP1
The profit for the firm
will be the rectangle
above the point on the
ATC curve (as shown)
The cost to the firm will
be the rectangle below
the point on the ATC
curve

0
Q
$
MC
P1
Q1
Q3
AVC
ATC
Marginal Cost Curve
Is the MC Curve = to the
firms supply curve?
Yes, if it is the portion above
the AVC
If a firms has a AVC > P, then
it will not be able to meet
payroll and will effectively go
into bankruptcy
This is not necessarily true
for when P is in between
AVC & ATC, as a firm will
continue to operate in the
short term in order to
minimize losses

0
Q
$
MC
P1
Q1
Q3
AVC
ATC
Average Total Cost
Q
Q
P$
+
MARKET SC
What will be the market supply curve?
Horizontal summation of individual firm supply curves
For profitable industries, firms will enter the market and the supply
curve will shift out (to the right)
For unprofitable industries, firms will exit the market and the supply
curve will shift in
P$ P$
P$
Q Q 8 12 9 13 5 10 22 35
+ =
Individual Firm Supply Curves
Comparative Statics
Suppose there was a change
in the costs for an industry
(e.g., lower energy costs)
The MC and ATC for a firm
would shift as shown
The market supply curve will
shift as well, resulting in a
lower market price and a
higher quantity
Dynamics: costs decline, 1
firm lowers price, all other
firms must then match price
0
Q
$
MC
ATC
ATC
MC
Q
P$
S2
S1
D
Q2 Q1
P2
P1
Comparative Statics
In general , 3 common types
of industry changes that will
affect the market supply curve
1) Change in number of firms
2) Change in costs
3) Change in technology
(usually considered like a
change in costs)
All affect supply curve and
change market similar to as
discussed before.

0
Q
P$
S1
D
S2
S3
Q2 Q3 Q1
P3
P1
P2
Market vs Individual Demand Curve
Q
MARKET DC
For a Price Taking firm, their demand curve is a flat line at the
market price
The market demand curve however, is downward sloping
For the price taking firm, they observe price (i.e., no pricing power)
Pm = market Price
P$
P$
Q
Individual Firm Demand Curve
D
S
Firm
DC
Pm
S
Marginal Cost Curve
Assume free entry and exit into a
market
ATC includes production costs,
managerial costs and
entrepreneurial opportunity costs
(i.e., includes a reasonable
return on investment)
Hence, market entry & exit will
be balanced when ATC = Pm
and therefore Economic Profit
= 0
For a firm in a perfectly
competitive market
(TC=Q1*ATC) and (TR=Q1*P1);
Economic Profit = TR TC = 0


0
Q
$
MC
Pm
Q1
Q3
ATC
Market Entry
MARKET
Does this make sense? Yes because Economic Profit or Super
Profit is profit over and above entrepreneurial costs
If there is Economic Profit in a perfectly competitive industry we
would expect more firms to enter
1) Assume Economic Profit present
P$
Qm
Individual Firm
D
S
0
Q
Pm
Q1
MC
ATC
Pm
P$
Economic Profit
Market Entry / Exit
MARKET
Since there is Economic Profit in the industry, there is incentive
for entrepreneurs to start new firms and enter the market
Market Supply curve shifts out (S to S) & Pm lowers to Pm
Firms will enter the market until no more Economic Profit present
At equilibrium there is only Accounting Profit and TR = TC
P$
Qm
Individual Firm
D
S
0
Q
Pm
Q
MC
ATC
Pm
P$
Economic Profit
now 0 as TR = TC
S
Pm
Pm
Market Exit
MARKET
Assume that sustained high energy costs have raised the cost
structure for some firms in a specific market
now for these firms (ATC > Pm) & TC > TR = Economic Loss
These firms will exit the market
P$
Qm
Individual Firm
D
S
0
Q
Pm
Q1
MC
ATC
Pm
P$
Economic Loss
Market Exit
MARKET
These firms exit the market and therefore the market supply curve
shifts in to S and market price raises to Pm
This restores equilibrium to the market
P$
Qm
Individual Firm
D
S
0
Q
Pm
Q
MC
ATC
Pm
P$
S
Pm
Pm
Qm
Summary
For Perfect Competition assume
free entry or exit
P = ATC = MC
Perfect Competition:
Homogeneous market, Large
number of buyers & sellers, free
entry & exit
Commoditization: products that
once werent homogenous, but
as competition evolves, these
products become standardized
(e.g., computer storage)



0
Q
$
MC
Pm
Q1
Q3
ATC