The economics of firms

Firm: an institution that hires factors of

production and that organises those factors to
produce and sell goods and services.

The assumption in ‘traditional’ microeconomic

models of firm behaviour is that firms
maximise profits.
Π : Greek pi used to denote profit
Π = total revenue – total costs
Main types of firms:

 sole trader
 partnership
 Company
 Public limited
 Private limited
Exceptions
 ‘not-for-profit’ firms (e.g. charities)
 pursuit of other goals in the short term (e.g.
sales maximisation)
 pursuit of multiple objectives: “satisficing”
 Asymmetry of information between the
owners of a firm (who wish to maximise
profits) and the managers of a firm (who may
wish to maximise prestige, their own salaries,
etc)
Production function
 The mathematical relationship between the
quantity of output of a good and the quantity
of inputs used to produce it.
 Specifically, the maximum output that can
be produced from quantities of the inputs.
 It shows how output will be affected by
changes in the quantity of one of more
inputs.
 Output = f(labour, capital, materials, land…)
 The distinction between ‘short
run’ and ‘long run’
 SR: time period during which at least one factor of
production (‘input’) is fixed
 Fixed factors: an input that cannot be increased
within a given time period (e.g. buildings)
 Variable factors: the firm can increase or
decrease the amount of these inputs.
 In the SR, output can only be increased by using
more of the variable factor.
 LR: time period long enough for all inputs to be
varied.
Production in the short run: Total
Product (TP)
L TP

a 0 0

b 1 4

c 2 10

d 3 13

e 4 15

f 5 16
Output (units per day)

f
16 e
TP
14 d
12

10
c
8

4 b
2
a
0
0 1 2 3 4 5 6
Labour (workers per day)
Total Physical Product

 “The total output of a product per period of time

that is obtained from a given amount of inputs.”
 Average Physical Product:
 Total output per unit of the variable factor
APP=TPP/Qv
 Marginal Physical Product:
 The extra output gained by the employment of one
more unit of the variable factor:
 MPP= ∆TPP/ ∆ Qv
 marginal product
L TP MP = ΔTP/ΔL
a 0 0
4
b 1 4
6
c 2 10
3
d 3 13
2
e 4 15
1
f 5 16
Output (units per
worker)

1 MP
0
0 1 2 3 4 5 6
Labour (workers per day)
The ‘law of diminishing marginal
returns’:

 As a firm uses more of a variable input, with

the quantity of fixed inputs constant, its MP
eventually diminishes.
Cost
 Opportunity Cost
 Explicit Cost
 Implicit Cost
 Historic Cost
 Replacement Cost
 Variable Cost
 Total Cost
 Average Cost
 Average Variable Cost
Cost and inputs
 Depends on
 Productivity of factors
 Price of factors
Costs in the short run
L TP MP FC VC TC = MC = AC =
(ΔTP/ΔL) FC + ΔTC/ΔTP TC/TP
VC

0 0 0 20 0 20 0 0

1 4 4 20 20 40 5 10

2 10 6 20 40 60 3.3 6

3 20 10 20 60 80 2 4

4 25 5 20 80 100 4 4

5 27 2 20 100 120 10 4.4

6 28 1 20 120 140 20 5
Costs (£)
VC

FC

output
 Total costs

TC
Costs (£)
VC

FC

output
Average and marginal costs

Costs (£ per MC
unit of output)

AC

output
The relationship between AC
and MC
If Marginal Cost… then Average Cost ..

is below is falling.
Average Cost,

is above is rising.
Average Cost,

is equal to is at a
Average Cost, minimum.
Average Fixed Cost
 Decreases as output increases, since total
fixed cost is constant
 Average Variable Cost:
 As average product of factor increases, average
variable cost per unit of output decreases
 Average Total Cost:
 Vertical sum of AFC and AVC curves
Long Run Production
 All inputs increased by same proportion

 The scale of production:

 Constant returns to scale
 Increasing returns to scale
 Decreasing returns to scale
Economies of scale
 Reasons:
 Specialization and division of labour
 Indivisibilities
 The Container principle
 Greater efficiency of large machines
 By-products
 Multi stage production
 Organizational economies
 Spreading overheads
 Financial economies
 Economies of scope
Dis-Economies of scale
 Management problem of coordination
 Repetitive tasks
 Location
The relationship between AC in the
short run and AC in the long run.
Cost of production
25
Long run AC

20

Short run (1) Short run (3)

AC
15 AC
Short run (2)
AC
10

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
output
 The long-run AC curve is the envelope of all
the short-run AC curves.
Cost of production
25

20

15 Long run AC

10

5
Increasing Constant Decreasing

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Quantity of the good produced
 Π = total revenue – total costs
 Maximum Π occurs where

 MR = MC

 How much a firm will choose to supply to a

market will depend on the economic profit
they can earn.
 This is determined both by:

 The characteristics of demand for their

product (determines revenue)
The characteristics of their production process
(which determines their costs)
Industrial market structure and
economic performance
 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly
Structure of the market or
industry
 Key features:
 Number of sellers
 Number of buyers
 Ability to enter and exit the market
 Availability of market information
Conduct and performance of
the market or industry
 Key features are:
 Price at which products are sold
 Quantity of products sold
 Profit levels
 Economic efficiency
The model of Perfect Competition
 Perfect competition is an extreme form of
market organisation where all firms in an
industry are price takers.
 Assumptions:
 Many firms selling homogeneous products
 Many buyers
 No restrictions on entry
 No restrictions on exit
 What is the purpose of the model of
perfect competition?
 Supply and demand for the
industry and the firm

Price Price
Ma rke t Supply

Firm’s de mand

Ma rke t De ma nd

Sell as much as
Quantity Quantity
they wish at the
Supply is the sum of firms’ supply.
market price.
. Demand curve for the firm
Price

Quantity

Price = Average Revenue = Marginal Revenue

Profit maximisation
Price
Ma rg in a l c o st

P2

P1

Q1
Quantity

Π maximizing Q:
MR = MC
 If the industry price increased to P2, what
is the new Π -maximising quantity chosen
by the firm?
 short run Marginal Cost defines the short
run supply curve for a price-taking firm.