Theory of the firm

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  • Images from istockphoto.com
  • Law of increasing returnConstantLaw of diminishing return
  • Total Fixed Costs (TFC) = total cost of fixed assets used in a given time period. TFC is constant amount.Total Variable Costs (TVC) = total cost of the variable assets that a firm uses in a given period of time. TVC increases as the firm increases output.
  • Average Fixed Cost (AFC) = fixed cost per unit = TFC/qAverage Variable Cost (AVC) = variable cost per unit = TVC/qAverage Total Cost (ATC) = total cost per unit = TC/q
  • Image Source: Flickr Member Tracy O
  • AR = Price and this falls as output increases as the price will be lowered in order to sell more productsMR falls but at a steeper rate MR is below the AR because the firm, in order to sell more products, has to lower the price and thus revenue is lost on the products that could have been sold at a higher price. In this way the firm will get more revenue from increased sales.TR rises then falls. At first the firm gains extra revenue by lowing price because more are sold but eventually this is outweighed by the loss in revenue from the units that were being sold at a higher price but must now be sold at a lower price.MR becomes a negative value when a loss of revenue results from lowering the price
  • images from istockphoto.com
  • While an accountant only considers tangible costs, revenue and profit, an economist also considers opportunity costTotal Profit for the accountant = Total Revenue – Total costs (variable and fixed)Total Profit for the economist = Total Revenue - Total Cost (viable, fixed and opportunity)
  • Rule:If a firm wishes to maximize profits, it should produce at the level of output where MC cuts MR from below.
  • To determine the amount of profit the AC must be added.
  • Normal profit is the minimum level of profit needed for a company to remain competitive in the market. Normal Profit takes place when TR = TC (fixed, variable and opportunity)AC is the key for a firm to avoid loss and do better than normal profits to achieve abnormal profits.
  • If a frim reduces its AC it will realize abnormal profits.
  • Some Entrepreneurs measure success by sales and revenue and they may not realize that they could make more profit by selling less and charging more. For strategic reasons, some firms may aim to increase market share in the short run.Maximizing Employment Some firms may aim to have a large workforce believing that to be a measure of success.Environment AimsSome firm may increase cost by buy more expensive but environmentally sustainable raw materialsSatisficing New theories suggest that firm are often run on behalf of shareholders and managers make enough to keep them satisfied.
  • Images form istockphoto.com
  • Time (e.g. peak and off peak rates)Age (usually child tickers and senior discounts)IncomeGeographical Distance e.g. CDs cheaper in US than EUType of Consumer e.g. domestic and industrial users of electricity
  • Time (e.g. peak and off peak rates)Age (usually child tickers and senior discounts)IncomeGeographical Distance e.g. CDs cheaper in US than EUType of Consumer e.g. domestic and industrial users of electricity
  • Increase profits Increase output to gain economies of scaleGain market share by predatory pricing Build brand loyaltyPromote goodwill e.g. free parking for the disabledTo achieve fairness e.g. higher income groups pay more for government provided child care, at some universities international students pay more than domestic student
  • Different market segment = different demand curvesArbitrage = reselling
  • Image from istockphoto.com
  • Firms are producing the optimal mix of goods and services required by consumers
  • Assumptions concerning Free CompetitionLarge number of firmsHomogeneous productsPrice takersPerfect knowledgeNo barrier to entry
  • Assumptions about MonopoliesOne firmPrice SetterBarriers to entry Some monopolies are considered Natural Monopolies i.e. barriers to entry are very high and the enjoys economics of scale where it can produce at a lower cost than many small firms combined e.g water supply, gas, electricity
  • Some monopolies are considered Natural Monopolies i.e. barriers to entry are very high and the enjoys economics of scale where it can produce at a lower cost than many small firms combined e.g water supply, gas, electricity
  • Images from istockphoto.com
  • This theory has been challenged as to its assumption that barriers to entry are minimal in nature. Empirical testing of the theory is still underway.
  • Theory of the firm

    1. 1. Theory of the Firm<br />Section 2.3 HL<br />
    2. 2. 2.3 A Tale of Two Firms<br />Apple is currently the most popular and well loved firm in the US while JAL, to the dismay of the Japanese, recently declared itself bankrupt with 2.3 Trillion Yen in debt. <br />How can one firm be so successful while fail so spectacularly?<br />
    3. 3. 2.3 A Tale of Two Firms and Theory of the Firm<br />What advice could an economist give Apple to help it stay so successful and what advice could they give JAL so that it once again becomes the most successful airline in Asia. <br />
    4. 4. Crucial Questions All Firm Face <br />
    5. 5. Theory of the Firm Defined<br />
    6. 6. Theory of the Firm The Goal<br />Provide advice <br />about the following:<br />The best price<br />The best output<br />The most profit<br />To breakeven price<br />The shutdown price<br />
    7. 7. Theory of the Firm<br />X<br />
    8. 8. Cost Theory<br />
    9. 9. Types of Costs: Fixed and Variable Costs<br />
    10. 10. Costs and Output (Product)<br />Variable Costs (VC)are the focus as Fixed Costs (FC)cannot change in the short term.<br />
    11. 11. Ways to Measure Output<br />
    12. 12.
    13. 13. The Total Product Curve<br />
    14. 14. Average and Marginal Product Curves<br />
    15. 15. Diminishing Average Returns<br />
    16. 16. Diminishing Marginal Returns<br />
    17. 17.
    18. 18. Total Costs<br />
    19. 19. Average Costs<br />
    20. 20. Marginal Costs<br />
    21. 21. TFC, TVC and TC<br />
    22. 22. Cost Curves<br />
    23. 23. LRAC A firm altering all its factors to meet increasing demand<br />
    24. 24. Economies and Diseconomies of Scale<br />
    25. 25. Economies and Diseconomies of Scale<br />
    26. 26. Economies of Scale<br />
    27. 27. Economies of Scale<br />
    28. 28. Revenue Theory<br />
    29. 29. Total Revenue<br />X<br />=<br />
    30. 30. Total Revenue<br />X<br />=<br />
    31. 31. Marginal Revenue<br />÷<br />=<br />
    32. 32. Revenue Curves<br />Example 1 Demand is perfectly elastic PED = Infinity<br />
    33. 33. Revenue Curves: Perfectly Elastic Demand<br />Price<br />D=AR=MR<br />5<br />Output<br />
    34. 34. Revenue Curves for Normal Demand Curves<br />
    35. 35. Profit Theory<br />
    36. 36. Accounting Profit<br />
    37. 37. Economic Profit<br />
    38. 38. Profit and Loss<br />Which firm is making a Profit, which is making and Abnormal Profit and which is making a loss? <br />
    39. 39. Profit and Loss<br />Abnormal Profit<br />Normal Profit<br />Loss <br />
    40. 40. What advice would you give these firms?<br />Shut Down Price and the Break Even Price <br />
    41. 41. Firm X should shut down as TR <TVC and TFC<br />Firm Y should continue production as TR >TVC.<br />Firm Z should continue to produce as TR >TVC<br />& part of its TFC<br />
    42. 42. Determining the Shut Down Price and the Break Even Price<br />
    43. 43. Shut Down Price<br />Break Even Price = P1 = ATC<br />
    44. 44. Profit Maximizing Level of Output<br />
    45. 45. Profit Maximizing Level of Output with Perfectly Elastic Demand<br />
    46. 46. Profit Maximizing Level of Output with Perfectly Elastic Demand<br />
    47. 47. Profit Maximizing Level of Output with Normal Demand<br />
    48. 48. Profit Maximizing Level of Output with Normal Demand<br />
    49. 49. Profit Maximizing Level of Output with Normal Demand<br />
    50. 50. Normal Profit Normal Demand<br />
    51. 51. Abnormal Profit Normal Demand<br />
    52. 52. Loss Normal Demand<br />
    53. 53. Is it always about profit?<br />
    54. 54. Profit, Sales and Revenue Maximization?<br />
    55. 55. Profit, Sales and Revenue Maximization?<br />
    56. 56. Profit, Sales and Revenue Maximization?<br />
    57. 57. Price Discrimination <br />
    58. 58. Definition<br />
    59. 59. Types of Price Discrimination<br />
    60. 60. Third Degree Discrimination<br />
    61. 61.
    62. 62. Pre-conditions for Price Discrimination<br />
    63. 63. Price Discrimination ExampleTotal Ticket Sales<br />
    64. 64. Price Discrimination ExampleAdult Tickets<br />
    65. 65. Price Discrimination ExampleAdult Tickets<br />
    66. 66. Price Discrimination Example<br />
    67. 67. Efficiency<br />
    68. 68. Productive Efficiency and Allocative Efficiency<br />
    69. 69. Productive Efficiency: Resources are not wasted<br />
    70. 70. Allocative Efficiency / Socially Optimum Level of Output<br />
    71. 71. Perfect Competition Versus Monopoly<br />
    72. 72. Perfect Competition Versus Monopoly<br />
    73. 73. Monopolies<br />
    74. 74. Competition & the Theory of Contestable Markets<br />
    75. 75. Efficiency<br />
    76. 76. Traditional Theories of Market Structure and Competition<br />Inverse Relationship<br />
    77. 77. Theory of Contestable Markets<br />Inverse Relationship<br />
    78. 78. Theory of Contestable Markets<br />
    79. 79. Theory of Contestable Markets<br />

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