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Theory of a Firm

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  • 1. Chapter 7 The Theory of the Firm
  • 2. Profits
    • Least expensive source of money for expanding business operations
    • Most firms attempt to maximize profit
    • Ultimately must break-even – cover their costs of production
    • Profits act as an incentive and reward
    • Use to evaluate how well firm is doing by comparing profit with competitors
  • 3. Types of Profit
    • Accounting profit – excess of revenues over costs (common idea of profit)
    • Economic profit - the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. This can be used as another name for "economic value added" (EVA).
    • To calculate economic profit, opportunity costs are deducted from revenues earned.  Opportunity costs are the alternative returns foregone by using the chosen inputs.
    • Can have a significant accounting profit with little to no economic profit.
  • 4. Costs
    • Explicit Costs: Sums of money actually paid out to non-owners of a business.
      • Examples include wages and payments to the suppliers of factors of production.
    • Implicit Costs Opportunity costs that come about as a result of using the owner’s resources.
      • Does not require an actual expenditure of cash.
      • Does include profit necessary to continue the business (normal profit)
  • 5. Profits Economic (opportunity) Costs T O T A L R E V E N U E Profits to an Economist Profits to an Accountant Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit
  • 6. Total Revenue
    • Money a firm receives from its sales
    • Revenue = Price x Quantity Sold
  • 7. Total Costs
    • Higher prices do not necessarily mean greater profit
    • Depends on the cost of production
    • Total cost of production: money firm spends to purchase the productive resources it needs to produce its good or service
    • Two basic categories: fixed and variable
  • 8. Fixed vs. Variable Costs
    • Fixed costs remain the same at all levels of output.
      • Must be paid regardless of whether or not the firm produces
      • E.g. rent, insurance, property taxes, interest
      • Difficult to adjust in the short term
      • Often referred to as overhead
    • Variable costs change with the level of production
      • As production increases more resources are necessary
      • Can be adjusted in the short term
      • E.g. raw materials, labour, fuel, power
  • 9. Short Run vs. Long Run
    • Short run: period over which the firm’s maximum capacity becomes fixed because of a shortage of one resource
    • Long run: period when all costs become variable.
      • Firm is able adjust fixed costs to increase production – they become variable costs
    • Not measured in fixed number of days, months, etc. as periods are different for various firms
  • 10. Returns to Scale
    • Economies of scale: The increase in efficiency of production as the number of goods being produced increases. 
    • Diseconomies of scale: Firms see an increase in marginal cost when output is increased.
    • Constant returns to scale: The cost for successive units remains constant
  • 11. Returns to Scale Constant Returns To Scale Diseconomies Of Scale Economies Of Scale
  • 12. Marginal Revenue and Marginal Cost
    • Marginal Revenue: additional revenue gained from selling one more unit
    • Marginal Cost: cost of producing one more unit
    • If a firm wishes to maximize profit, it should produce up to the point where there is no added benefit from producing any more.
    • Produce to the point where marginal cost equals marginal revenue
  • 13. Example
  • 14. Try this problem…
    • Price $20
    • Quantity Sold, 0 to 100, increase by 10
    • Fixed Costs $540
    • Variable Costs, see chart
    • Calculate: Revenues, Total Costs, Profit, Marginal Cost, Marginal Revenue
    1850 100 1512 90 1264 80 1064 70 870 60 725 50 580 40 450 30 315 20 175 10 0 0 VC Quantity
  • 15. Making Production Choices
    • Productivity: maximizing the output from the resources used
    • Efficiency: producing at the lowest cost
      • Measured in cost per unit and unit labour cost
    • Firms are at a competitive disadvantage if their productivity/efficiency decreases or their competitor’s productivity/efficiency increases
  • 16. Labour vs. Capital Intensive Production
    • Labour-intensive: industries/methods where labour, rather than machinery, dominates the production process
      • Good when labour is plentiful and cheap
      • Low fixed costs
      • Variable costs adjusted to meet demand
    • Capital-intensive: industries/methods where machinery, rather than labour, dominates the production process
      • Good for economies of scale - larger potential for profit
      • High fixed costs
      • Difficult to increase production in short-run or decrease costs