Theory of a firmPlekhanov Russian Economics University

MICROECONOMICS

Costs, revenue and profits• The economic definition of cost• The ECONOMIC COST for a firm is the opportunity cost of production.• Resources which have an opportunity cost but for which no payment

is made must have an IMPUTED COST.• The opportunity cost of labour of, say, a trader on a local market must

be included as an economic cost of production.• The opportunity cost of production must include the opportunity cost

of start-up capital.

Opportunity cost-2• The economic cost of DEPRECIATION is the difference between the

purchase price and the second hand value of a good.• The GOODWILL of brands has an opportunity cost. They could be sold

to a rival company.

Fixed and variable costs• A FIXED COST (also called an INDIRECT or OVERHEAD COST) is a cost

which does not vary directly with output (rents, advertising and promotion, plant and machinery, offices).• A VARIABLE (or DIRECT or PRIME) COST is a cost which varies directly

with output (raw materials for instance).• SEMI-VARIABLE COSTS. Firms do adjust staff numbers with output,

but the adjustment is sluggish and therefore the cost of labour is neither variable nor fixed – it is semi-variable.• In the short run some costs are fixed costs while others are variable.

In the long run all costs will be variable.

Total, average and marginal cost

(1) (2) (3) (4)Output

(per week)Total

variable cost

Total fixed cost

Total cost(2+3)

0 0 200 2001 200 200 4002 300 200 5003 600 200 8004 1200 200 14005 2000 200 2200

The TOTAL COST (TC) of production is the cost of producing a given level of output. TVC + TFC = TC

Average cost• The AVERAGE COST OF PRODUCTION is the total cost divided by the level of

output.

AC

AVERAGE VARIABLE COST (AVC) is total variable cost divided by the level of output.AVERAGE FIXED COST (AFC) - is total fixed cost divided by the level of output.

Average cost-2(1) (2) (3) (4)

Output(per week)

Average variable

cost

Average fixed cost

Average cost

(2+3)1 200 200 4002 150 100 2503 200 67 2674 300 50 3505 400 40 440

Marginal cost• MARGINAL COST is the cost of producing an extra unit of output.

MC

(1) (4) (2)Output

(per week)Total cost

Marginal

cost per unit of output

1 400 4002 500 1003 800 3004 1400 6005 2200 800

Total, Average and Marginal Revenues

• A firm’s revenues are its receipts of money from the sale of goods and services over a time period such as a week or a year.• TOTAL REVENUE (TR) is the total amount of money received from the

sale of any given level of output.• AVERAGE REVENUE (AR) is the average receipt per unit sold.• MARGINAL REVENUE (MR) is the receipts from selling an extra unit of

output.

• MR = TRn – TRn-1• where n and n-1 are the last and the last but one good sold

respectively.

Profit• The PROFIR of a company can be calculated by taking away its total

cost from its total revenue:• Profit = TR – TC• It can also be calculated by finding the average revenue minus

average cost, and multiplying that by the quantity sold.• The profit which is counted as an economic cost, is called NORMAL

PROFIT.• ECONOMIC PROFIT (also called PURE PROFIT or ABNORMAL PROFIT

or SUPERNORMAL PROFIT) is the profit over and above normal profit.

Dunning on profitThomas Joseph Dunning (1799 –1873) was a British trade-unionist: “Capital is said by a Quarterly Reviewer to fly turbulence and strife, and to be timid, which is very true; but this is very incompletely stating the question. Capital eschews no profit, or very small profit, just as Nature was formerly said to abhor a vacuum. With adequate profit, capital is very bold. A certain 10 per cent. will ensure its employment anywhere; 20 per cent. certain will produce eagerness; 50 per cent., positive audacity; 100 per cent. will make it ready to trample on all human laws; 300 per cent., and there is not a crime at which it will scruple, nor a risk it will not run, even to the chance of its owner being hanged. If turbulence and strife will bring a profit, it will freely encourage both. Smuggling and the slave-trade have amply proved all that is here stated.”

SHORT RUN COSTS:the effect of diminishing returns

Units CostsCapital Labour Total

physical product (output)

Marginal physical product

Total cost Average cost Marginal cost

TVC TFC TC AVC AFC ATC MC

10 0 0 0 0 1000 1000 0 - - 10 1 20 20 200 1000 1200 10 50 60 10,010 2 54 34 400 1000 1400 7,4 18,5 25,9 5,910 3 100 46 600 1000 1600 6,0 10,0 16,0 4,310 4 151 51 800 1000 1800 5,3 6,6 11,9 3,910 5 197 46 1000 1000 2000 5,1 5,1 10,2 4,310 6 230 33 1200 1000 2200 5,2 4.3 9,6 6,110 7 251 21 1400 1000 2400 5,6 4,0 9,6 9,510 8 260 9 1600 1000 2600 6,8 3,8 10.0 22,2

Labour and physical product

Labour Total physical product

1 202 453 604 70

The cost of the capital employed is 200 000 r. The firm can employ any number of workers at a constant wage rate per unit of labour of 50 000 r. if we employ:(a)1 unit if labour; (b) 2 units of labour; (c) 3 units of

labour; (d) 4 units of labour;what is the value of the following:(1)Total fixed costs;(2)Total variable costs;(3)Total costs;(4)Average fixed costs;(5)Average variable costs;(6)Total average cost;(7)Marginal cost?

Economies of Scale• In the long run, all factors of production are variable.• ECONOMIES OF SCALE effect is observed when long run costs fall as

output increases.• DISECONOMIES OF SCALE effect is observed when long run average

costs (LRAC) begin to rise.• CONSTANT ECONOMIES OF SCALE effect is observed when long run

costs are stable.

Productive efficiency• is said to exist when production takes place at lowest cost.• Since in the long run average cost curve is U-shaped, this will occur at

the bottom of the curve when constant returns to scale exist.• The output range over which average costs are at a minimum is said

to be the OPTIMAL LEVEL OF PRODUCTION.• The output level at which the lowest cost production starts is called

the MINIMUM EFFICIENT SCALE (ES) of production.

Economies or Diseconomies?Output(million units)

Long run average cost (in roubles)Firm A Firm B Firm C Firm D Firm E

1 10 20 16 19 202 8 18 14 18 173 5 16 15 17 154 5 11 17 16 145 5 10 20 15 146 5 10 24 14 147 6 11 30 13 14

For each firm, A to E, give:(1) the range of output over which there are:(a)economies of scale;

(b) diseconomies of scale;

(2) the optimum level or range of output;(3) the minimum efficient scale of production.

Sources of economies of scale• Technical economies and diseconomies of scale are those which exist

because of increasing and decreasing returns to scale effect.• Managerial economies assume the advantages of specialization among

the staff.• Purchasing and marketing economies stem from the fact that the larger

the firm the more likely it is to be able to buy raw materials in bulk.• Financial economies. Small firms often find it difficult and expensive to

raise finance for new investment.• Diseconomies of scale arise mainly due to management problems.

Movements along and shifts in the long run average cost curve• An increase in output which leads to a fall in costs would be shown by a

movement along the LRAC curve.• INTERNAL ECONOMIES OF SCALE, discussed so far, arise because of the growth of

output of the firm.• EXTERNAL ECONOMIES OF SCALE arise when there is a a growth in the size of the

industry in which the firm operates.• Taxation. If the government impose a tax upon industry, costs will rise, shifting the

LRAC curve of each firm upwards.• Technology. Introduction of better technology will push the LRAC curve downward.• External diseconomies of scale will shift the long run average cost curve of

individual firms in the industry upwards.

The relationship between the short run and the long run

average cost curves• In the short run, at least one factor of production is fixed. Short run

average costs at first fall, and then begin to rise because of diminishing returns, in the long run, all factors are variable. Long run average costs change because of economies and diseconomies of scale.• In the long run, a company is able to choose a scale of production

which will maximize its profits.• The long run average cost curve is said to be the envelope for the

short run average cost curves because it contains them all.

ISOQUANTS AND ISOCOST LINES• There is a variety of techniques which a firm can use. Labour can be

substituted for capital in the production process. However, the more labour is used, the greater the amount that needs to be substituted to replace I unit of capital.

Labour Capital100 2070 3040 4420 7012 100

Units needed to produce1 million chocolate bars

Isoquants• AN ISOQUANT is a line which shows different combinations of inputs

needed to produce a given level of output efficiently.• The isoquant shows the most efficient form of production possible. It

is possible to produce I million chocolate bars with the combinations of factors of production above the curve. But these input combinations would be less productively efficient than an input combinations on the isoquant.• Family of isoquants. Isoquants can be drawn for every production

level of chocolate bars.

Isocost lines• An ISOCOST LINE shows the combinations of factor inputs which a

firm can buy with a given budget.• The slope of the isocost line reflects the relative process of inputs.• If the firm is able to increase its budget, it will be able to buy more

labour and capital.• If the relative price of inputs does change, then the slope of the

isocost curve will change too.

Cost minimisation• By combining isoquants and isocost lines, it is possible to explain which

combination of factors a firm will use in its production process.• A firm will minimize its production costs by choosing the point where

the isocost line is tangential (just touches) the isoquant.

Factor substitution• If the price of labour increases when the price of capital remains the

same, a firm will react by using less labour and more capital. In other words, capital will be substituted for labour.

MARKET STRUCTURES• are characteristics of a market which determine firms’ behavior. They

include:• the number of firms in the market and their relative size;• the number of firms that might enter the market;• the ease or the difficulty of entry;• the extent to which goods in the market are similar;• the extent to which all firms share the same knowledge;• the extent to which the actions of one firm will affect other firms.

The number of firms in an industry• A MONOPOLY is said to exist when there is only one supplier in the

market.• OLIGOPOLY is domination of a few large producers in a market.• PERFECT COMPETITION is a market structure when there is a large

number of small suppliers, none of which is large enough to dominate the market.

• Market structures are also affected by the potential number of new entrants to the market.

Barriers to entry• are the obstacles which prevent potential competitors from entering an

industry.• Capital costs.• Sink costs are costs that are not recoverable.• Economies of scale – if established producers, operating at the optimal

level of production, satisfy all the market demand, than newcomers will produce at greater costs. A NATURAL MONOPOLY exist where one firm can beat off any competitors because it produces at the lowest possible cost.• Natural cost advantages.

• Legal barriers. The law can give firms particular privileges. Patent laws can prevent competitors from making a product for a given number of years after its invention.• Marketing barriers. Existing firms in an industry may be able to erect

very high barriers through high spending or advertising and marketing.• Restrictive practices. Firms may deliberately restrict competition

through restrictive practices.

• Barriers to entry can be innocent and deliberate.

Product homogeneity and branding

• Goods which are identical are called HOMOGENEOUS goods.• Differentiating their product from their competitors, and creating

BRANDS allows firms to build up brand loyalty.

KNOWLEDGE• Buyers and sellers are said to have PERFECT INFORMATION or

PERFECT KNOWLEDGE if they are fully informed of prices and output in the industry.