Theory of the Firm (HL): Production and costs

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Long run: period of time in which all factors of production are variable. All planning takes place in the long run.

Short run: period of time in which at least one factor of production is fixed. All production takes place in the short run.

The length of the short run depends on the time it takes to increase the quantity of the firm’s fixed factors.

Fixed factors: normally capital or land, but could also include a type of highly skilled labour.

In order to increase output in the short run, more units of the variable factors must be applied to the fixed factors, while the firm plans to change the number of fixed factors.

Total product (TP): total output that a firm produces, using its fixed and variable factors in a given period of time.

Average product (AP): output that is produced, on average, by each unit of variable factor.

AP= TP/V

Marginal product (MP): extra output produced by using an extra unit of the variable factor.

MP=ΔTP/ΔV

Law of diminishing returns: as extra units of a variable factor are added to a given quantity of fixed factor, the output per unit of the variable factor will eventually diminish. This happens in the short run.

In an example of a cake shop fixed factors include:

  • Work space

  • Ovens

  • Cooking equipment

It is efficient to add bakers up to a certain point, but because of the fixed factors, after this point adding workers is less efficient – too many cooks spoil the broth.

Economic cost

Explicit costs: factors that are purchased from others and not already owned by the firm. These costs involve a direct payment of money.

For instance, for hiring a baker, the opportunity cost is the cost of wages and other things that the money could have been spent on.

Implicit costs: factors that are already owned by the firm. These are the earnings that a firm could have had if it had employed its factors in another use or if it had hired out or sold them to another firm.

For example, the head baker is paid $13 per hour, but he could have taken the job of an accountant at $34 per hour so the implicit cost is this difference in salary.

Short run costs

Total fixed cost (TFC): total cost of fixed assets that a firm uses in a given time period.

It remains constant and is independent from the number of units produced, e.g. rent, equipment costs etc.

TFC = Fixed assets x cost per asset

Total variable cost (TVC): total cost of variable assets that a firm uses in a given time period.

It increases as the firm uses more of the variable factor, e.g. wages, cost of ingredients etc.

TVC = Variable assets x cost per asset

Total cost (TC): total cost of all fixed and variable assets used to produce a certain output.

TC = TFC + TVC

Average total cost (ATC): total cost per unit output. ATC falls and then rises with output.

ATC = TC/Q

Average variable cost (AVC): variable cost per unit output. AVC falls as output increases and then increases due to diminishing returns.

AVC = TVC/Q

Average fixed cost (AFC): fixed cost per unit output. Because TFC is constant, AFC always falls as output increase.

AFC = TFC/Q

Marginal cost (MC): the increase in total cost of producing an extra unit of output. MC falls as output increases and then rises due to diminishing returns.

MC = ΔTC/ΔQ

Long run costs

The long run average cost curve (LRAC) is an envelope curve, is it envelopes an infinite number of short run average cost curves (SRAC)

If the demand increases and the firm wishes to increase quantity produced, then more than one variable factor can be used in the short run to move along the SRAC curve to produce more.

In order to then decrease the cost per unit, the firm must move into the long run and change all of its factors. So it will move into the next curve, SRAC2.

Increasing returns to scale: long run unit costs are falling as output increases. A percentage increase in all factors of production causes a greater percentage increase in output, long run average costs decrease.

Constant returns to scale: long run unit costs are constant as output increases. A percentage increase in all factors of production causes a directly proportional percentage increase in output, long run average costs are constant.

Decreasing returns to scale: long run unit costs are increasing as output increases. A percentage increase in all factors of production causes a smaller percentage increase in output, long run average costs are increasing.

Economies of scale: an increase in input leads to a more than proportionate increase in output and LRAC falls. It happens in the long run and leads to increasing returns to scale.

  • Promotional economies: costs of advertising normally do not rise in direct proportion to output, so cost per unit falls.

  • Transport economies: large bulk orders may not charge delivery costs and larger firms can afford their own cheaper fleet, which does not include other firms’ profit margins.

  • Large machines: machinery may be too expensive for small firm, so they must rent it, which includes other firms’ profit margins.

  • Bulk buying: larger firms may be able to negotiate discounts with suppliers. The cost of inputs and unit cost of production is reduced.

  • Financial economies: banks usually charge lower rates to larger firms (less risk), insurance is likely to be less and loans are more easily accepted.

  • Division of labour: breaks production process down into smaller activities that workers can perform repeatedly and quickly.

  • Specialisation: a larger firm is able to have more management specialised to different roles, thus making the firm more efficient.

Diseconomies of scale: an increase in input leads to a less than proportionate increase in output and LRAC increase. It happens in the long run and leads to decreasing returns to scale.

  • Alienation and loss of identity: in very large firms workers and managers may lose a sense of belonging and loyalty, while feeling insignificant. So they become less productive and unit costs increase.

  • Control and communication: a larger firm has a greater need for effective communications as the management will find it harder to control and coordinate the firm, so communication breaks down and unit costs increase.

Internal economies and diseconomies of scale: economies of scale relating to the unit cost decrease or increase that might be encountered by a single firm.

External economies and diseconomies of scale: economies of scale relating to the whole industry that effect the unit cost of individual firms.

Revenues

Total revenue (TR): total amount of money that a firm receives from selling a certain amount of good or service in a given time period.

TR = P x Q

Marginal revenue (MR): the extra revenue the firm gains when it sells one more unit of product in a given time period.

MR = ΔTR/ΔQ

Average revenue (AR): the revenue the firm receives per unit of sales.

AR = TR/Q =PQ/Q = P

Revenue when price does not change with output: (when PED is infinite) the AR, MR and demand remains the same. TR increases at a constant rate as output increases.

Revenue when price falls as output increases: (when PED falls as output increase) AR (P) falls as output increases, so MR falls at a greater rate than AR. TR rises and then falls because the extra revenue gained from dropping the price and selling more units is outweighed by the loss in revenue from the units that were being sold at a higher price and now have a lower price.

MR is negative because when the price is lowered revenue is lost on the products that could have been sold at a higher price. This causes TR to fall.

When PED is unitary any firm wishing to increase revenue should leave the price unchanged, since revenue is already maximised.

When PED is elastic any firm wishing to increase revenue should lower its price, as it will cause a relatively large increase in quantity demanded.

When PED is inelastic any firm wishing to increase revenue should raise its price, as it will cause a relatively small decrease in quantity demanded.

Profit

Total profit = Total revenue – Economic cost (explicit and implicit)

Normal profit (zero economic profit): total revenue equals total costs.

Abnormal profit (economic profit): total revenue is greater than total costs.

Loss (negative economic profit): total revenue is less than total costs.

Breakeven price: price where a firm can make normal profit in the long run. So all costs are covered including opportunity costs (price=ATC). If price does not cover ATC in the long run, the firm will shut down permanently.

The profit maximising level of output: if a firm wishes to maximise its profits, it should produce at the level of output where MC cuts MR from below. The AC curve must be cut by the MC at the AC’s minimum.

Shut down price: level of price that enables a firm to cover its variable costs in the short run (price = AVC).

If price does not cover AVC then it will shut down in the short run.

Alternative goals of the firm

Corporate and social responsibility: a firm includes ‘public interest’ in its decision making, adopting an ethical code that accepts responsibility for the impact of activities on areas like workers, consumers, local communities and the environment. This builds up brand loyalty.

Satisficing: it is likely that the managers make enough profit to keep the owners of the firm happy.

Growth maximisation: a firm may aim to achieve growth in the short run, to gain a large market share and dominate the market in the long run.

Revenue maximisation: a firm may maximise their sales by producing where MR = 0. This is above the profit maximising level of output.

Perfect competition

Assumptions of a perfectly competitive market:

  • No barriers to entry or exit: firms are free to join and leave the market, without regulation, patents, and high fixed costs. Normal profits in the long run.

  • Perfect knowledge: producers are aware of market prices, costs in the industry and workings of the market. Consumers are fully aware of prices, quality and availability of goods/services

  • Identical homogeneous products: there is no differentiation in the product, such as branding or marketing

  • Many individual buyers: no has any control over the market price

  • Perfectly mobile factors of production: land, labour and capital can change in response to market conditions

  • Large number of small firms: each firm has an extremely small share of the market share, so cannot affect the markets’ output, supply curve or price of the industry. So they are price takers.

Examples for a perfectly competitive market include the EU wheat market, the watermelon market and milk.

The firm must sell at the industry’s price otherwise consumers will go elsewhere. The firm can sell any amount at this price, as it has no effect on the industry.

Possible short run profit and loss situations in perfect competition

By profit maximizing the firm is minimizing its losses as any other output would result in a greater loss.

Maximizing profits: producing at MC = MR.

The firm is not covering its total costs.

The firm’s revenue is covering more than their total costs, including opportunity costs.

Short run losses to long run profits

Results in a bigger industry, with smaller firms.

Short run abnormal profits to long run normal profits

Results in a smaller industry, with larger firms.

When no losses or abnormal profits exist, there is a long run equilibrium situation. So no one leaves or enters.

Productive and allocative efficiency in perfect competition

In both of these diagrams producing at Q is profit maximizing (MC=MR) and allocative efficient (MC=AR), but it is not productive efficient (MC=AC).

Here the firm is producing at profit maximizing level (MC=MR), allocative efficient (MC=AR) and productive efficient (MC+AC) level of output in the long run.

Monopolistic competition

Assumptions of monopolistic competition:

  • Products are differentiated: consumers can recognize differences, like colour, brand, quality etc.

  • No barriers to entry or exit: firms are free to join and leave the market, without regulation, patents, and high fixed costs. Normal profits in the long run.

  • Small scale/local advertising: widely used to make product less elastic.

  • Collusion is impossible: too many firms to make and maintain an agreement.

  • Imperfect knowledge: amongst consumers and producers, though almost perfect.

  • Fairly large number of relatively small firms: one firm’s actions has little impact on others – independent.

Examples of a monopolistic competition include nail salons, car mechanics, plumbers and jewellers.

Possible short run profit and loss situations in monopolistic competition

Demand is more elastic than in a monopoly but less than in perfect competition

Abnormal profits and losses can only be made in the short run.

In the short run, a firm produces at profit maximizing (MC = MR), but not productive (MC = AC) nor allocative (MC=AR) level of output in a monopolistic competitive market

The long run equilibrium of the firm in monopolistic competition

This diagram shows profit maximizing (MC=MR), but not productive (MC=AC), not allocative (MC=AR) level of output. Costs including the opportunity costs are covered, so there is no incentive to leave the market. Firms no longer enter as abnormal profits are not being made and their entrance would lead to loses for the whole industry.

The firms are not productive or allocative efficient because of consumers’ desires for a variety. So consumers are prepared to pay slightly higher prices for more choice.

Oligopoly

Assumptions of an oligopoly market:

  • Interdependent: may collude to act as a monopoly and maximize industry profits. Very sensitive to rivals’ prices, products, advertising and locations.

  • High barriers to entry or exit: usually large scale production or strong branding of dominant firms. Also high fixed costs, expertise, knowledge and contacts.

  • Non price competition: price tends to remain the same incase other firms so not follow

  • Products are differentiated: some are less or more than others, e.g. location, quality etc.

  • Few large firms: high concentration ratio of output in a few firms with high market influence.

Examples for oligopoly include oil companies, motor cars, shampoo products, coffee shops and supermarkets

Non collusive oligopoly

Competing firms have no agreement concerning their behavior and tactics.

Kinked demand curve

Price increase is elastic and price decrease is inelastic, so any change in price causes TR to fall.

Increasing or decreasing MC has no effect on MR. It only has an effect on the firm’s profitability.

Collusive oligopoly

Collusive oligopolies act with a monopolist’s power, so the graph is the same. Therefore, abnormal profits occur in the short run and into the long run.

Monopoly

Assumptions of a monopoly:

  • Imperfect knowledge: specialized information and production techniques are unavailable to potential producers.

  • Unique product: no close substitutes.

  • One large firm: the firm is the industry so has complete market share.

  • High barriers to entry or exit: stops new firms entering, thus allowing abnormal profits in the long run.

Examples for monopoly include Microsoft, train lines and electricity providers.

Sources of monopoly power

Economies of scale: these benefit monopolists as they have large firms, whereas new entrants would face higher average costs, as they cannot exploit bulk buying, specialisation etc., as much.

Anti-competitive behaviour: monopolists adopt restrictive practices, legal or illegal. For instance they are in a strong position to start a price war. They would reduce their price to a loss making level which they would be able to sustain for a longer period of time than the new entrant.

Brand loyalty: consumers refer to the product as the brand, e.g. Hoover vacuum cleaners. Potential entrants believe that they cannot sufficiently differentiate themselves to generate strong brand loyalty.

Legal barriers: patents, copyrights and trademarks encourage invention in innovative products, as they can cause the firm to be protected from rivals, so it becomes a monopoly. The government can also grant individual firms to produce a certain product by nationalising its industry, e.g. postal service, and banning other entrants.

Natural monopoly: if there are only enough economies of scale to support one firm, if another firm entered, normal profits could not be made, let alone abnormal.

Possible profit situation in a monopoly

A firm can make abnormal profits in the long run because the effective barriers to entry prevent profits being competed away.

Producing at profit maximising level of output (MC=MR), but productive (MC=AC) and allocative (MC=AR) inefficient.

Monopolists do not always make profits as there may simply be no demand.

Revenue maximisation in a monopoly

Instead of profit maximising (MC=MR) the monopolist revenue maximises (MR=0). This is likely to please consumers as the price is less with greater output.

Disadvantages of monopoly:

  • Lower competition – poor service/good, dated

  • Lack of consumer sovereignty and choice

  • High prices, anti-competitive behaviour

  • Profits not invested – only employees benefit

  • Diseconomies of scale – due to poor management

  • Allocative and productive inefficient.

Advantages of monopoly:

  • Avoids duplication and wastage of resources

  • Benefits from economies of scale – large profits or lower consumer prices.

  • Large profits to fund research and development – latest technologies improve efficiency

  • Lower competition and advertising calls.

Price discrimination

Price discrimination: a producer sells identical products to different consumers at different prices. The price is not justified by a difference in cost.

  • The producer must have price setting ability, so the market must be imperfect. It is therefore usually in a monopoly or oligopoly.

  • Markets must be clearly separated to prevent consumers buying the product at the lower price and selling it on

  • Consumers must have different price elasticities to be prepared to pay different prices.

First degree price discrimination: individuals pay different prices depending on their willingness to pay.

Second degree price discrimination: individuals pay according to their consumption (utility companies).

Third degree price discrimination: clearly separated markets for different prices charged.

Producers separate markets by:

  • Time e.g. train

  • Age e.g. cinema

  • Gender e.g. football club

  • Income e.g. lawyers

  • Geographical distance e.g. DVDs

  • Types of consumers e.g. market trader

Evaluation of price discrimination

Advantages for the firm:

  • Consumer surplus eliminated – higher revenue from sales

  • Producer produces more – economies of scale, lowering average costs and prices

  • In the elastic market, competitors may be driven out – the firm undercuts them by using revenue from inelastic market to lower elastic prices.

  • Makes use of spare capacity

  • May increase research and development

Advantages to the consumers:

  • Consumers of the elastic sector find prices more affordable

  • Increasing total output makes products more available to more consumers

Disadvantages to the consumers:

  • Any previous consumer surplus is lost

  • Consumers with inelastic demand may have to pay ore – exploitation

  • Increase revenue and competitive behaviour may allow a firm to gain monopoly power.

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