Theory of the Firm

Section 2.3 HL
2.3 A Tale of Two Firms
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.

How can one firm be so

successful while fail so
spectacularly?
2.3 A Tale of Two Firms and
Theory of the Firm
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.
Crucial Questions All Firm Face

How should the firm

How should the firm What is the best
reduce costs, be
use resources to price to obtain the
efficient and
make a profit? most revenue?
maximize profits?

How many units How should the What are the

should the firm firm plan for the advantages and risks
produce to make the future in terms of of the firms market
most revenue? price and quantity? environment?

How can the firm

respond to the
business cycle?
Theory of the Firm Defined

Cost Theory
Theories about a firm’s
behavior in the market
place, the nature of that Revenue
market place and how Theory
they produce and price
their goods.
Profit Theory
Theory of the Firm
The Goal
► Provide advice
► about the following:
► The best price
► The best output
► The most profit
► To breakeven price
► The shutdown price
Theory of the Firm
TR
Quantity X Price

-
Fixed Costs Variable Costs

=
Profit
Cost Theory
Types of Costs: Fixed and Variable
Costs

Fixed Variable
Costs Costs
Costs and Output (Product)

Variable
Costs
Variable Costs
(VC)are the focus
as Fixed Costs
Fixed (FC)cannot change
Costs in the short term.

Product
Ways to Measure Output

Average Product (AP)

Total Product (TP)=
= TP/V (Units of the
total output of a firm
Variable Factor)

Marginal Product
(MP) = Change in
TP/Change in V (Units
of the Variable Factor)
The Total Product Curve
Average and Marginal Product
Curves
Diminishing Average Returns

As extra units of a VF are added to a given

quantity of a FF, the output per unit of the
VF will eventually diminish
Diminishing Marginal Returns

As extra units of a VF are added to a given

quantity of a FF, the output from each additional
unit of the VF will eventually diminish.
Total Costs (TC) = total cost to produce a
certain output. TC = TFC + TVC

Total Variable
Costs (TVC) = Total Fixed Costs
total cost of the (TFC) = total cost
variable assets of fixed assets
that a firm uses in used in a given
a given period of time period.
time.
 Total Costs
Total
Fixed
Costs
(TFC)
Total
Costs
Total
TC
Variable
Costs
(TVC)
 Average Costs
Average
Average Fixed
Variable Costs
Costs (AFC)
(AVC)

Average Total
Costs
(ATC)
 Marginal Costs
Marginal Cost
(MC) = increase
in TC of
producing an
extra unit of
output
TFC, TVC and TC
Cost Curves
LRAC
A firm altering all its factors to meet increasing demand
Economies and Diseconomies of
Scale

Diseconomies of scale
Economies of scale LRAC
LRAC  as Output
 as Output constant
constant

Constant returns to scale

LRAC is constant as Output

Economies and Diseconomies of
Scale
Economies ofFinancial
Scale Transport
Savings Savings

Bulk Buying
Technology
of Inputs

Economies Advertising
Specialization and
of Scale promotion
Economies of Scale
Control and Alienation/work
Communication satisfaction

Diseconomies
of Scale
Revenue Theory
Total Revenue

Quantity X Price

Total
= Revenue
Total Revenue

Quantity X Price

Total
= Revenue
Marginal Revenue

Change in Change in
Revenue ÷ Quantity
Marginal
= Revenue
Revenue Curves
Example 1 Demand is perfectly elastic PED = Infinity
Price ($) Demand TR AR MR
(q)
5 1 5 5 5
5 2 10 5 5
5 3 15 5 5
5 4 20 5 5
5 5 25 5 5
5 6 30 5 5
5 7 35 5 5
Revenue Curves: Perfectly
Elastic Demand

Price
D=AR=MR

Output
Revenue Curves for Normal
Demand Curves
Profit Theory
Accounting Profit

Debit Total
Total Revenue
Fixed Costs

Debit Total
Profit Variable
Costs
Economic Profit

Debit Total Debit Total

Total Revenue
Fixed Costs Variable Costs

Debit
Profit Opportunity
Costs
Profit and Loss
Firm A Firm B Firm C
TR 200,000 200,000 200,000
TFC 40,000 40,000 40,000
TVC 80,000 100,000 120,000
Opportunity Cost 60,000 60,000 60,000
TC 180,000 200000 220,000

Which firm is making a Profit, which is making

and Abnormal Profit and which is making a
loss?
Profit and Loss
Firm A Firm B Firm C
TR 200,000 200,000 200,000
TFC 40,000 40,000 40,000
TVC 80,000 100,000 120,000
Opportunity Cost 60,000 60,000 60,000
TC 180,000 200000 220,000
Abnormal Profit Normal Profit Loss
 Firm X Firm Y Firm Z

TR 80,000 120,000 150,000

TFC (including 100,000 100,000 100,000

OC)

TVC 100,000 120,000 140,000

TC 200,000 220,000 240,000

Loss 120,000 100,000 90,000

What advice would you give these firms?

Shut Down Price and the Break Even

Price
 Firm X Firm Y Firm Z

TR 80,000 120,000 150,000

TFC (in OC) 100,000 100,000 100,000

TVC 100,000 120,000 140,000

TC 200,000 220,000 240,000

Loss 120,000 100,000 90,000

Firm X should shut down as TR <TVC and TFC

Firm Y should continue production as TR >TVC.
Firm Z should continue to produce as TR >TVC
& part of its TFC
Determining the Shut Down Price
and the Break Even Price

Shut Down Break Even

Price = AVC Price = ATC
Shut Down Price

Break Even
Price = P1 =
ATC
Profit Maximizing Level of Output

When MR > MC then

a firm should increase
production until
MC = MR
Profit Maximizing Level of Output
with Perfectly Elastic Demand
Profit Maximizing Level of Output
with Perfectly Elastic Demand
Profit Maximizing Level of Output
with Normal Demand
Profit Maximizing Level of Output
with Normal Demand
Profit Maximizing Level of Output
with Normal Demand

The profit per unit of

Therefore P = AR at
output must be the
q – AC at q X
difference between
Quantity (q)
the AR and the AC.
Normal Profit Normal Demand
Abnormal Profit Normal Demand
Loss Normal Demand
 Is it always about profit?
Revenue and Maximizing
Sales Employment
maximization • Large workforce
• Strategic = = Success
increase market
share in SR.
• Ignorance

Environment Satisficing
Aims • Keep
Incur added costs shareholders
to be satisfied with
environmentally performance
sustainable.
Profit, Sales and Revenue
Maximization?
Profit, Sales and Revenue
Maximization?
Profit, Sales and Revenue
Maximization?
Price
Discrimination
Definition

Price Discrimination

• When firms actively adjust

prices according to the
willingness/ability of
different consumers to pay.
Types of Price
Discrimination

First Degree Second Degree Third Degree

• charge • discount for • market

whatever quantity separated
the market purchases into distinct
will bear e.g. groups
auction.
Third Degree
Discrimination

Time
Location •peak and off peak
•books in Australia toll roads
and US

Income Age
•Means tested •seniors, adults
government and children
services

Type
•domestic and
industrial uses of
electricity
 Gain market
share by Build brand
predatory loyalty
pricing

Increase output
and gain from Promote
economies of goodwill
scale

Reasons for
Achieve
Increase profits Price fairness
Discrimination
Pre-conditions for Price
Discrimination

Different market
Firm have Arbitrage can be
segments
market power limited
identifiable
Price Discrimination Example
Total Ticket Sales
Price Discrimination Example
Adult Tickets
Price Discrimination Example
Adult Tickets
Price Discrimination
Example

Charging New TR=

Charging Students $7 $3600
Adults are less Adults $9 yields $2800
MC = MR price sensitive yields $1800
therefore the (400 x $7)
600 tickets at MR Curve is (200 x $9)
$5 kinked.
TR = $3000
Efficiency
Productive Efficiency and
Allocative Efficiency

Productive Efficiency is Allocative Efficiency is

achieved when goods are achieved when resources
produced at the lowest are not wasted i.e. Supply
possible cost per unit., i.e. = Demand and Price =
Minimum Average Cost MC
Productive Efficiency:
Resources are not wasted
Allocative Efficiency / Socially
Optimum Level of Output
Perfect Competition Versus
Monopoly
Perfect Competition Versus
Monopoly
 Pros of Cons of
Monopolies
Monopolies Monopolies
Competition & the Theory of
Contestable Markets
Efficiency
Traditional Theories of Market
Structure and Competition

Number of
Degree of
Firms in
Competition
Market

Inverse Relationship
Theory of Contestable Markets

Barriers to
Actual Degree
Entry of
of Competition
Potential Rivals

Inverse Relationship
Theory of Contestable Markets

Accordingly
If market is firms will firms will greater
contestable perceive a behave efficiency and
(low barriers threat of competitively lower prices
to entry), competition. will result
and
Theory of Contestable
Markets

If cost of entry and

exit is zero In reality most
(perfectly firms when
contestable entering a market
Threat of
market), firms will will be faced with
competition
challenge a firm sunk cost, i. e. costs
influences price and
that is making that can not be
output of all firms
abnormal profits recouped by
and therefore that transferring them
firm will keep to another use.
prices low.