Theory of the firm

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 Production Function
Mathematical representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon the amount of
capital (K), Land (L) and Labour (La) available
The ease with which this can be varied
depends upon the individual firm

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 Costs

In buying factor inputs, the firm will incur costs

Costs are classified as:
Fixed costs costs that are not related directly to
production
Variable Costs costs directly related
to variations in output.

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 Fixed Costs
Also called overhead or unavoidable costs.
Do not vary with output.
Include rent paid on the premises, rates,
interest payments on loans and hire purchase
repayments.

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 Variable costs
Do vary with output.
Include raw materials, wages of the operative
staff and the cost of fuel. When no output is
produced, no variable costs are incurred.
Also called direct or avoidable costs.
In the long run, all the factors of production are
variable, and so all costs are variable.

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 Total cost
The total cost of producing a particular level of
output.
Total cost can be divided into total fixed cost (TFC)
and total variable cost (TVC)
so that: TC = TFC + TVC

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Total cost (Continued)

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 Costs
Total Cost - the sum of all costs incurred in
production
TC = FC + VC
Average Cost the cost per unit
of output
AC = TC/Output
Marginal Cost is the addition to total cost from
producing one extra unit of output. Marginal cost is
entirely variable cost.
MC= change in total cost
change in total output
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 Average total cost
Average total cost is the cost per unit and is
obtained by dividing total cost by the number
of units produced. Average total cost (ATC)
comprises average fixed cost and average
variable cost
so that: ATC = AFC + AVC
Average fixed cost is given by AFC = TFC/Q
Average variable cost is given by AVC = TVC/Q

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 Marginal cost
Marginal cost is the change in the total cost as
a result of a change in output of one unit.
What is the importance of marginal analysis to
a firm?

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Average and marginal cost

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 Costs
Short run Diminishing marginal returns
result from adding successive quantities of
variable factors to a fixed factor
Long run Increases in capacity can lead to
increasing, decreasing or constant returns to
scale

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 Long run cost
In the long run all the factors of production are
variable.
The long-run average cost (LRAC) curve is the
envelope to all the short-run average cost
curves.
LRAC represents the lowest cost of producing
different levels of output when all factors can
be varied.

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LRAC

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 Economies of scale
Refers to the fall in the long-run average cost
curve as output increases.
Technical economies: relate to the increase in
size of the plant or production unit.
Non-technical economies: relate to the
increase in size of the enterprise as a whole.

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 Non-technical economies of scale
Financial economies
Administrative, marketing and other functional
economies
Distributive economies
Purchasing economies.

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 Revenue
Total revenue the total amount received from
selling a given output
TR = P x Q
Average Revenue the average amount received
from selling each unit
AR = TR / Q
Marginal revenue the amount received from
selling one extra unit
of output

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 Profit
Profit = TR TC
The difference between revenues and costs
The reward for enterprise
Profits help in the process of directing
resources to alternative uses in free markets
Relating price to costs helps a firm to assess
profitability in production

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 Different Levels of Profit
Normal Profit
The minimum level of profit required to keep a
firm in its current line of business
Abnormal/Supernormal Profit
Any profit that is made over and above normal
profit
Subnormal Profit
A level of profit which is below normal profit

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 Normal Profit
Normal Profit the minimum amount
required to keep a firm in its current line of
production
If a business is not making normal profit the
owners will normally either
Move into a different market using their factors of
production
Cease trading and use their skills elsewhere

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 Other Objectives
Remember; not all firms seek to maximise
profits
Market Share
e.g. UK supermarket chains
Overall size
Perhaps true of smaller businesses
Highest Quality
Bentley, Rolex . etc

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