Theory of the Firm I

Short Run & Long Run

A time period during which at least one input is fixed and cannot be changed by the firm

Long Run

A time period when all inputs are flexible (can be changed) / No fixed capital / variable inputs

Short Run

Relationship between MP & AP

The Law of Diminishing Returns / The law of diminishing marginal products

As more and more units of variable inputs are added to one or more fixed inputs. MP of variable input first increase, but there will be a point when it begin to decrease
When MP = Maximum = Point of Law of diminishing returns

Cost of Production: Economic Cost

All = Opportunity cost = Economic cost = (Explicit cost + Implicit cost)
Cost of production includes money payments to buy resources + anything given up by a firm for the use of resources (Opportunity cost)

2 types of Economic cost

Cost of production in the short run

Fixed cost only occurs in short-run since there is no fixed inputs in the long-run
If fixed cost > loss, a firm will still choose to operate since they still need to pay with the fixed cost even if closed

Derivatives of Costs

Relation between MC & MP / AP & AVC curves

*As cost increases, product will decrease, and vice versa

Cost of Production in the long Run

Returns to scale: Production in the long-run

Constant Returns to scale

Output increases in the same proportion as the increase in inputs / Output increase by the same percentage

Increasing returns to scale

Output increases greater than the proportion as the increase in inputs / Output increases by larger percentage

Decreasing returns to scale

Output increases lower than the proportion as the increase in input / Output decreases by smaller percentage

LRATC curve

Curve shows the lowest possible average cost that can be attained by a firm for any level of output when all of the firm’s inputs are variable. Tangent to many SRATC curves

When a firm varies inputs that were fixed in the short run, it changes it sizes or scale in order to decrease the cost
LRATC is a curve made of multiple SRATCs
When a firm wants to increase it output, it must going into the long run ( to make fixed input variable)

Economies of Scale

Economies of scale will decrease in the average cost of production over the long run as firm increases all its inputs

*Falling AVC + Increase in output suggested that firms in economies of scale will experience an ‘increasing returns to scale’

How to create Economies of Scale?

Specialization of labour
Specialization of management
Efficiency of capital
Indivisibilities of capital equipment
Indivisibilities of efficient processes
Spreading certain costs

Diseconomies of Scale

In diseconomies of scale, the output produced is smaller than the proportion of the increase in variable input
Cost increases as the quantity increases

Reasons for diseconomies of scale

Coordination and monitoring difficulties
Communication difficulties
Poor working motivation

The minimum efficiency scale (MES) / structure of industries

Minimum efficient scale - A point in the LRATC curve represents the lowest level of output at which lowest LRATC is achieved. Point which economies of scale is exhausted
See Qmes on Fig2.

Revenues

Revenues are payments firms received when they sell the goods and services. They produce over a given period.

Profits

There are 2 types of profits - Economic Profit & Normal Profit

Economic Profit = TR - economist cost = TR - (explicit costs + implicit costs)

Normal Profit (Break-even point)

When economic profit = 0, TR = total economic cost
Minimum amount of revenue that firm must receive so that it will keep the business running
Amount of revenue covers all implicit

*Why running a business even with zero Economic profit

Because when a firm earns a normal profit, it means that its total revenue is able to cover all its implicit and explicit cost. Therefore it means the firm covered all its opportunity cost, so it can continue to operate.

Positive & Negative Economic Profit

Goals of Firms

Determining the best level of output that the firms should produce in order to maximize the benefits under different considerations

3 common goals