Theme 3
, “Theory of the Firm”
Practice - business growth, natural monopoly and regulation, privatisation/ nationalisation
BUSINESS BEHAVIOUR
Theory - cost and revenue theory, market structures, alternative views
Stylised models
LABOUR MARKET Most important market - Number and size of
- Need to work (e.g. PPF) firms
- Main/ only source of household income Perfect - Barriers to entry
- Inequality and social mobility competition,
- State of information
monopolistic
- Nature of products
MODEL OF PRODUCTION comp, oligopoly
and monopoly
L
L G +S
C PROFIT = REVENUE - COST THE LAW OF DIMINISHING RETURNS
- states that as successive units of variable factors are added
to the fixed factors, the extra output will at first increase
Production: (due to efficiency) and then decrease
- Occurs in the short run (period of
time in which at least one factor is Output = total product (TP) no of units of variable factors = VL
fixed)
- Organised by entrepreneurs - AP = TP/VL
combing FOP and take risks and Marginal product = ΔTP/ ΔVL
reward
Marginal product - change in output from employing one extra
E.g. we assume land and capital are fixed Long run - period of unit of variable factors
and numbers of workers will be variable time in which all
No workers = output is 0 factors are variable Diminishing returns set in after the peak
Add workers = rising output AP is the highest when cut by MP from above
, Cost family and cost curves
Variable costs (costs of variable factors) - costs that change with the level
Total cost = fixed
of production (quantity increases, VC increases etc)
COSTS cost + variable cost
- Production will incur costs
Fixed costs (cost of the fixed factors) - costs that do not change with the
TC = FC + VC →
level of production (cost of producing nothing)
private costs which
we assume has no
Average cost - cost per unit produced Marginal cost - cost of producing one more unit of output externalities
AC = TC/Q MC = ΔTC/ ΔQ ΔQ = MP
ΔTC = determined by variable costs
● AFC - fixed costs per unit of output (TFC/Q)
● AVC - variable costs per unit of output (TVC/Q)
● AC = falls initially but then will rise after it’s been cut from below by MC
● MC = first declines, hits a low and then rises (“nike swoosh”)
● AC is influenced by relative size of fixed cost
● AVC and AC get closer because AFC falls as Q increases
● AVC falls and starts to increase AFC vs AVC
● Where AC = MC (cuts from below) we achieve productive efficiency
(most efficient combination of factors of production)
1. MC
2. AC from “low” PSD
Bigger FC = flatter AC
Shut down price
- P >/= to AVC the firm is covering VC
- If P>VC = covering some of their FC so should carry on
producing in the LR as it is a smaller loss than if they
SD
Long run SD → if you cannot cover AC then leave the industry
, Cost
Long run cost curves
SRAC1
Economies of scale
SRAC2
LRAC - The process by which long run average cost declines as the scale of output increases
SRAC3 SRAC4 Diseconomies of scale →
Envelope curve “Envelops” lowest point on lowest AC curves for all levels of output
“Return” - what you get back from something
Increasing Decreasing “Scale” - size
returns to returns to As we add successive “bundles” of FOP to increase the size of the firm, the extra output
scale scale
Economies Diseconomies
(from given investments of inputs) will at first increase and then decrease
of scale of scale Cost
Output LRAC Sources of economies of scale
MES a) Output rises faster than the cost (productivity) - increasing
Minimum
return to scale
efficient scale - b) Cost rises by less than output (buying power)
smallest output Because logically, LRAC = TC/Q
and which LRAC Output c) Specialisation of workers (assigned to best task, learn by
MES
is minimised
doing)
Constant returns d) Specialisation of managers e.g. factory manager, finance
to scale director, purchasing manager, transport manager, HR
director
e) Use of large machines (expensive, only justified when
i) Advertising and promotion - fixed costs of advertising and
output reaches a certain scale - replaces humans and
promotion will be spread over more units AND star firms may
increases productivity)
benefit from lower rates
f) Bulk purchasing - firm can buy inputs on a more efficient
scale and at a lower cost per unit
→ Shows the lowest possible average cost that can be obtained
g) Transport costs - man with a van, hauliers, own fleet
for any level of output when all the firm's inputs are variable
AC of distribution falls as Q rises
h) Financial economies - small, new firms may struggle to
access bank credit. Large established firms easily pay low
rates for lower risk. Vary big girls can issue bonds and sell
shares on public markets
, “Theory of the Firm”
Practice - business growth, natural monopoly and regulation, privatisation/ nationalisation
BUSINESS BEHAVIOUR
Theory - cost and revenue theory, market structures, alternative views
Stylised models
LABOUR MARKET Most important market - Number and size of
- Need to work (e.g. PPF) firms
- Main/ only source of household income Perfect - Barriers to entry
- Inequality and social mobility competition,
- State of information
monopolistic
- Nature of products
MODEL OF PRODUCTION comp, oligopoly
and monopoly
L
L G +S
C PROFIT = REVENUE - COST THE LAW OF DIMINISHING RETURNS
- states that as successive units of variable factors are added
to the fixed factors, the extra output will at first increase
Production: (due to efficiency) and then decrease
- Occurs in the short run (period of
time in which at least one factor is Output = total product (TP) no of units of variable factors = VL
fixed)
- Organised by entrepreneurs - AP = TP/VL
combing FOP and take risks and Marginal product = ΔTP/ ΔVL
reward
Marginal product - change in output from employing one extra
E.g. we assume land and capital are fixed Long run - period of unit of variable factors
and numbers of workers will be variable time in which all
No workers = output is 0 factors are variable Diminishing returns set in after the peak
Add workers = rising output AP is the highest when cut by MP from above
, Cost family and cost curves
Variable costs (costs of variable factors) - costs that change with the level
Total cost = fixed
of production (quantity increases, VC increases etc)
COSTS cost + variable cost
- Production will incur costs
Fixed costs (cost of the fixed factors) - costs that do not change with the
TC = FC + VC →
level of production (cost of producing nothing)
private costs which
we assume has no
Average cost - cost per unit produced Marginal cost - cost of producing one more unit of output externalities
AC = TC/Q MC = ΔTC/ ΔQ ΔQ = MP
ΔTC = determined by variable costs
● AFC - fixed costs per unit of output (TFC/Q)
● AVC - variable costs per unit of output (TVC/Q)
● AC = falls initially but then will rise after it’s been cut from below by MC
● MC = first declines, hits a low and then rises (“nike swoosh”)
● AC is influenced by relative size of fixed cost
● AVC and AC get closer because AFC falls as Q increases
● AVC falls and starts to increase AFC vs AVC
● Where AC = MC (cuts from below) we achieve productive efficiency
(most efficient combination of factors of production)
1. MC
2. AC from “low” PSD
Bigger FC = flatter AC
Shut down price
- P >/= to AVC the firm is covering VC
- If P>VC = covering some of their FC so should carry on
producing in the LR as it is a smaller loss than if they
SD
Long run SD → if you cannot cover AC then leave the industry
, Cost
Long run cost curves
SRAC1
Economies of scale
SRAC2
LRAC - The process by which long run average cost declines as the scale of output increases
SRAC3 SRAC4 Diseconomies of scale →
Envelope curve “Envelops” lowest point on lowest AC curves for all levels of output
“Return” - what you get back from something
Increasing Decreasing “Scale” - size
returns to returns to As we add successive “bundles” of FOP to increase the size of the firm, the extra output
scale scale
Economies Diseconomies
(from given investments of inputs) will at first increase and then decrease
of scale of scale Cost
Output LRAC Sources of economies of scale
MES a) Output rises faster than the cost (productivity) - increasing
Minimum
return to scale
efficient scale - b) Cost rises by less than output (buying power)
smallest output Because logically, LRAC = TC/Q
and which LRAC Output c) Specialisation of workers (assigned to best task, learn by
MES
is minimised
doing)
Constant returns d) Specialisation of managers e.g. factory manager, finance
to scale director, purchasing manager, transport manager, HR
director
e) Use of large machines (expensive, only justified when
i) Advertising and promotion - fixed costs of advertising and
output reaches a certain scale - replaces humans and
promotion will be spread over more units AND star firms may
increases productivity)
benefit from lower rates
f) Bulk purchasing - firm can buy inputs on a more efficient
scale and at a lower cost per unit
→ Shows the lowest possible average cost that can be obtained
g) Transport costs - man with a van, hauliers, own fleet
for any level of output when all the firm's inputs are variable
AC of distribution falls as Q rises
h) Financial economies - small, new firms may struggle to
access bank credit. Large established firms easily pay low
rates for lower risk. Vary big girls can issue bonds and sell
shares on public markets
